hey there i'm james and in this video you'll learn how basic accounting works from start to finish for the past three years i've spent most of my time making these free accounting tutorials to help people study pass their exams or get a deeper understanding for their own businesses we've covered a lot of different topics and the order has been a little random at times so what i've done is pick out my favorite videos and arrange them in a logical progressive order the result of which is this almost five hour long accounting epic it's a biggie but i put the timestamps and links to the originals down in the description i've also made cheat sheets for all of the topics covered today so if you'd like to support the channel then you're welcome to buy those on my website the link is in the description too and quickly before we jump in i'd like to say a big thanks to all my channel members you guys helped make this possible thanks for your support let's do this we'll start with the accounting cycle accounting is like a big tree it's been around for ages and it has lots of branches there's financial accounting managerial tax audit and bookkeeping but generally i think when people say accounting they usually mean financial accounting so what is financial accounting it's the process of identifying recording summarizing and analyzing an entity's financial transactions and reporting them in financial statements hey i'm james and if this definition doesn't mean much to you it's all good stick around me for the next 10 minutes or so and you'll see exactly how financial accounting works we've got a lot to cover but i do recommend watching this right through to the end at least once so that you can get an idea of the big picture let's do this imagine that you own rough times a tabloid newspaper covering all the latest gossip on our furry friends during march you run a promotional offer for annual subscriptions that begin on april 1st people can't get enough of your stories and you end up with thousand dollars in new subscriptions all paid for in cash the first step in financial accounting is to identify the transaction well that's easy i just mentioned one you made forty thousand dollars in new annual subscriptions these start on april 1st and continue through to march 31st next year so what next then it's time to prepare a journal entry a journal is a record of a financial transaction and it looks like this you have a unique journal number a date a description the accounts affected in this case that's cash and subscription revenue and then you have your debits and credits which are both 40 000 rough times is a serious business so you're using double entry accounting which means this transaction affects at least two accounts and the total debits are equal to the total credits but why do we do it this way what is double entry accounting the first thing you need to know is that financial accounting is built on one simple idea the stuff that your business owns is equal to the stuff that your business owes we call the stuff that your business owns assets these are valuable resources that you'll benefit from in the future things like cash and inventory but on the other side of this formula we use two different words to describe the stuff that your business owes liabilities when you owe stuff to third-party lenders or suppliers these are your obligations that you'll need to fulfill in the future and equity when rough times owes stuff to you the owner this represents your claim on the businesses net assets so assets equal liabilities plus equity this little formula is called the accounting equation and it has big implications it was written down a long time ago by this guy in this book and it revolutionized the way we record transactions it's the foundation of double entry accounting the theory that there are at least two equal and opposite sides to every transaction because this accounting equation is always true it must always balance debits and credits are the words we use to reflect these two sides credits represent the sources that economic benefit flows from whereas debits represent the destinations that it flows to nowadays pretty much every large business in the world uses double entry accounting and so does rough times in this case you debit cash by forty thousand dollars to increase your assets and you credit subscription revenue by forty thousand dollars to record your income are you hanging in there i know there's a lot to take in and some of these terms might not make sense right away but that's okay just give it some time and let it all seep in after this you can always jump into my accounting basics playlist explore everything i mention in a lot more detail i'll drop a link to that down below in the description just below that big red subscribe button i don't know what voice that was but anyway the next step is to post the journal into your general ledger the general ledger is a place where you store all of your financial data it contains a complete record of your accounts and journal entries back in the day it used to be this huge book that you'd fill out by hand but thankfully we've moved on now and businesses like yours use accounting software which treats the general ledger as kind of a central database so how do we get this journal into your general ledger you post it to your accounts accounts are places where you record sort and store all transactions that affect a related group of items broadly speaking there are six types of account assets liabilities and equity which we already know from the accounting equation and then there's revenue expenses and withdrawals also known as dividends these feed into the equity part of the equation if you'd like to see how and why that works then you can check out my video on equity i'll pop a link to that in the description this journal affects two accounts and we can pitch what they look like by drawing out two t's and labeling them cash and subscription revenue these are called t accounts and they help us visualize what your accounts look like debits go on the left and credits go on the right when you post this journal you debit the left hand side of your cash account by forty thousand dollars and you credit the right hand side of your subscription revenue account by 40 000 as well when we total these up you now have 48 000 in cash and you've made 75 000 in subscription revenue but rough times has other accounts too it has a whole collection of assets liabilities equity revenue and expense accounts stored in your general ledger you post this journal during march when you collect the cash but now let's fast forward to the end of your financial year to december 31st we need to put together your unadjusted trial balance what's a trial balance it's an internal report that summarizes the closing numbers in all of your general ledger accounts it can help us check for errors but ultimately we use it to make financial statements as you'll soon see but what does it look like here's your general ledger again and now let's jump ahead to the end of december building a trial balance is actually quite simple you list out all of your accounts and their closing balances and that's all there is to it a closing balance is the cumulative total of all transactions affecting an account as usual debits are on the left and credits are on the right at the bottom of your trial balance you have your total debits and total credits these should match each other exactly because the accounting equation is always true trial is another way of saying test which is what the trial balance was originally used for as a test to check that your debits and credits are in balance and this is an unadjusted trial balance because we haven't adjusted it yet but we will now actually because you've ended a financial year so we need to post some adjusting entries adjusting entries are journal entries that bring your books in line with something called the accrual method of accounting what's that to understand you really need to know about the accounting rule books yes accountants have to be good and follow the rules but the rules change a bit depending on where you're based you might follow the international financial reporting standards or some variation of the generally accepted accounting principles ifrs or gaap these two rulebooks make sure that your financial statements reflect a true and fair view of your business which is important because a lot of people rely on financial statements particularly those who've lent you money or invested in your business anyway ifrs and gaap have one major thing in common they both want you to follow the accrual method of accounting which means you need to recognize your revenue as you earn it and record your expenses as you incur them this is the most accurate way to calculate your profit but here's the thing rough times hasn't been playing by the rules in march you ran a promotion for annual subscription starting on april 1st you collected in cash and posted a journal to recognize that whole amount as revenue on march 31st this is called cash accounting and it's not the same as a call accounting in cash accounting you recognize your revenue as you receive cash and record your expenses as you pay it out but receiving cash is not the same as earning revenue let me show you you received forty thousand dollars of cash during march but you actually earn that revenue over the next 12 months this is when you do the work this is when you release each issue of rough times so today as things stand on december 31st you've recognized 12 months of income this financial year we haven't earned three months of it yet and you won't until the end of march next year but it's all good that's what adjusting entries are for these are the journal entries that you post to bring your books in line with your crawl method we can fix this situation by reversing 3 out of 12 months of your subscription revenue which is 10 000 and temporarily holding it as a liability in an account called deferred revenue or unearned revenue this is a liability account because you still have an obligation at the end of the year to provide your customers with rough times from january to march let's post this one to your general ledger and run ourselves a new adjusted trial balance this time it's adjusted because you've posted your adjusting entries we can see that your subscription revenue has gone down by ten thousand dollars and your liabilities have gone up by ten thousand dollars your debit and credit totals still match each other because there were two equal and opposite sides to the journal and now you're playing by the rules because you're following the accrual method of accounting nice one now we can create your financial statements financial statements are accounting reports that summarize your businesses activities over a period of time these are external reports designed to give your investors lenders and creditors an understanding of your business's financial health the three main financial statements are called the balance sheet the income statement and the cash flow statement we can build all of these using your adjusted trial balance your balance sheet looks like this it gives us a snapshot of your business's assets liabilities and equity at a single point in time which can teach the readers about your financial position they can see what you own and what you owe at the end of your financial year now let's check out your income statement this summarizes your businesses revenues and expenses over a period of time here that's the previous year and it gives the readers a glimpse of your financial performance and profitability if you were cash accounting then this income statement would also mirror your cash flows but you're using the accrual method so profit and cash flow aren't the same thing you keep track of your cash flows separately in a cash flow statement this report summarizes your cash inflows and outflows over the same period of time once you've created these three financial statements you can send them out to your investors lenders and creditors if rough times was listed on a stock exchange then investors all around the world would compare your performance against their expectations and decide whether to buy or sell shares in your business they'd analyze your statements using financial ratios which is something that we haven't covered on this channel yet so if you'd like to see some videos on that then by all means please let me know down in the comments but we're not finished yet once you're done with your financial statements you need to post some closing entries to prepare your books for next year a closing entry is a journal entry that you post to clear out all of your temporary accounts like revenues expenses and dividends for rough times your journal would look something like this you'd debit your revenue accounts and use credit to your expense accounts to clear them down to zero the balance of six thousand four hundred and forty dollars goes to retained earnings in the equity section of your balance sheet these are your profits that you're holding on to for the future so if we look at your trial balance again then we can see your revenue and expense accounts have been reset to nil and now you're ready to tackle the new year together these steps make up the accounting cycle and this is what financial accounting is all about it's the process of identifying recording summarizing and analyzing your business's financial transactions and reporting them in financial statements wowza we covered a lot there didn't we i promise i don't expect all of that to make sense right away but i do think it's important that you get to see the big picture for the rest of this video walk through all the steps of the accounting cycle at more leisurely pace and we'll begin with the accounting equation the key principle behind the accounting equation is that stuff the business owns is equal to the stuff that the business owes and it is vitally important that you remember that this equation balances always always always now let's say i come up with this amazing idea for a business i want to make popcorn and sell it i've got five dollars in my pocket and i decide to lend it to the business now there is a word to describe the stuff that the business owns and that is called assets on the other side of the accounting equation we actually have two different words to describe what the business owes and that depends on who the lender is we use liabilities to describe what the business owes to third parties and we use equity to describe what the business owes to its owner in this case me so assets equal liabilities plus equity there we have it the full accounting equation simple hey so that five dollars that my popcorn business now has is called an asset and that five dollars that my business owes back to me is called equity see it balances assets can include things like cash accounts receivable inventory plant property and equipment land in buildings investments and goodwill whereas liabilities can be made up of accounts payable loans payable wages payable and taxes payable amongst other things the most common forms of equity are stockholders or owners equity and retained earnings i will cover retained earnings in detail in a further video but for now you can just think of it as profit held for future use now let's add some totals to the above and see if this thing still balances of course it does the accounting equation always balances and a balance sheet is basically a snapshot of our different assets liabilities and equity at a single point in time a balance sheet is one of the most important financial statements there is a lot you can tell about a business by looking at its balance sheet right so at the beginning of this video i promised you a couple of examples so here we go if i head down to the shop and spend five dollars on corn then i no longer have five dollars in cash but i now have five dollars of inventory the categories have now changed but my total assets stay the same my balance sheet is in balance now i need to pop this coin but i don't have enough money to then buy a pot so i go to one of my friends and i ask them if i can borrow ten dollars the businesses cash increases by ten dollars and loans payable go up by ten dollars as well total assets are now fifteen dollars and my liabilities plus my equity are now also fifteen dollars we're still in balance i then go and spend this ten dollars on a pot my cash goes down by ten dollars and my equipment goes up by ten dollars let's say i go and sell this first batch of popcorn at a 60 percent markup on cost so i've made sales of eight dollars all my inventory has now gone however i now have eight dollars in cash and have made a small profit of three dollars my profit is three dollars because my sales were eight dollars and my corn cost me five dollars to buy eight less five is three dollars remember i said that we can think of retained earnings as profit held for future use so my retained earnings are going to increase by three dollars because my business has made a profit of three dollars my total assets have now increased from fifteen dollars to eighteen dollars so to recap in this video we have learned that stuff that the business has is equal to the stuff that the business owes this can be reworded to form the accounting equation assets equal liabilities plus equity this equation always balances the expanded accounting equation forms the balance sheet and a balance sheet is a snapshot to a businesses assets liabilities and equity at a single point in time interesting but what are debits and credits in this video i'm going to explain to you what debits and credits aren't define them and show you why this is going to help you out to properly understand debits and credits i think it's important to make a couple of points clear so we can remove any misconceptions debits and credits are neither good nor bad debits and credits are not the same as adding or subtracting debits and credits are words used to reflect the duality or double-sided nature of all financial transactions if you need an analogy to help you visualize this then you can think of debits and credits as heads and tails on a coin since there are equal and opposite sides to every transaction in the world of finance money doesn't magically appear or disappear for money to go to one account has to come out from another accountants consider every transaction to involve a flow of economic benefit from a source to a destination what is economic benefit economic benefit is the potential for an asset to contribute either directly or indirectly to the flow of an entity's cash i was saying that accountants consider every transaction to involve a flow of economic benefit from a source to a destination well credits represent the source and debits represent the destination destinations that economic benefit can flow to include assets like cash buildings and amounts owed to you by others but also expenses where a business pays a third party for a good or service they have provided and dividends where a business distributes some of its cash to its owners on the other hand sources that economic benefit can flow from include owner's equity where businesses owners give their cash to the business liabilities such as amounts owed to a bank in exchange for a loan or to suppliers for providing a good or service and revenue so let's bring back up that accounting equation that we discussed in the previous video and i'll prove this to you assets equal liabilities plus equity now we know that assets are represented by debits and liabilities by credits however equity is a tricky one to understand it properly we have to expand it into the components that make it up now full disclosure here we're about to do some maths don't be afraid we're just gonna do some simple rearrangement here if mass isn't your thing maybe watch this next section through a couple of times so you can wrap your head around it you'll be okay equity equals owner's equity paid in less dividends paid out plus retained earnings i said in the previous video that we can think of retained earnings as profit held for future use well profit is made up of revenue less expenses so let's replace retained earnings in our accounting equation with revenue less expenses we have equity equals owner's equity paid in less dividends plus revenue less expenses and now let's take this definition of equity and break it out in our accounting equation assets equal liabilities plus owner's equity paid in less dividends plus revenue less expenses and finally let's do a little rearrangement so we have dividends plus expenses plus assets equal liabilities plus owner's equity paid in plus revenue the left hand side represents debits these increase when debited and decrease when credited the right hand side is the opposite these are credits these increase when credited and decrease when debited now i mentioned at the start of the video that i have a tip for you to remember all this this is gonna help you out well here it is dealer if you are ever in doubt which side of the accounting equation these terms sit on then you only have to remember this one word dealer right i think we covered a lot there so let's recap some of those main points debits and credits are words used to reflect the duality or double-sided nature of all financial transactions debits represent the flow of economic benefit to the destination credits represent the flow of economic benefit from the source debits include dividends expenses and assets credits include liabilities owner's equity paid in and revenue this is reflected through the accounting equation which can be expanded and rearranged to show as dividends plus expenses plus assets are equal to liabilities plus owner's equity paid in plus revenue an easy way to remember this is dealer before we move on i'd like to clear something up that i know a lot of people find confusing it certainly confused me when i was studying accounting and that is why are debits and credits the other way around in banking why are debits and credits backwards in banking i've said in previous videos that cash is an asset which is a normal debit balance so debits increase it and credits decrease it however when i deposit money into my bank account they credit my account which increases my balance and when i withdraw money to go and pay for something they debit my account which decreases my balance we appear to have a direct contradiction here i'm going to explain why that is not the case to solve this little puzzle we need to put ourselves into the shoes of the bank from the bank's point of view our checking account is a liability not an asset if we go to the bank and deposit money into our checking account the bank debits their cash to increase it and it credits its amounts owing to us because it owes us that money back whenever we want we can go down to the bank and withdraw our money from our checking account so from the bank's perspective checking accounts are liabilities not assets liabilities are normal credit accounts so credits increase liabilities and debits decrease liabilities from the customers point of view nothing has changed the checking account is still an asset to the customer debits increase assets and credits decrease assets so there we have it debits and credits aren't backwards in banking it's all about perspective from the customer's point of view their checking account is an asset but from the bank's point of view their checking account is a liability what are t accounts to kick things off i would like to lay out the definitions of some important terms that will crop up throughout this video first what is an account an account is a place where we can record sort and store all transactions that affect a related group of items a t account is a visual representation of an account it is called a t account simply because it looks like a t and it looks like a t so that we can easily distinguish between all of the debits and credits that impact it finally what is the general ledger it's a place where a business stores a complete record of all of its financial transactions and accounts now that i've clarified these terms let's get back to t accounts in its most simple form a t account looks like this debits go on the left credits go on the right if you are having a hard time remembering the sides you can add a little dr and cr to the top of the t account dr and cr are how we accountants write debits and credits in shorthand last week i taught you a simple way to remember which accounts are debits and credits dealer d e a l e r dealer dividends expenses and assets go on the left these increase when debited and decrease when credited whereas liabilities owner's equity paid in and revenue go on the right these increase when credited and decrease when debited now we will run through a quick example to illustrate this let's say your business has a cash account with a hundred dollars in it that's your opening balance you take out forty dollars to pay a bill and then you decide to take out twenty five dollars more to buy some new supplies so you are left with thirty five dollars in the account which we will call your closing balance balance by the way is another way of saying total as a point in time so here your opening balance means your total cash at the beginning and your closing balance means your total cash at the end typically when you are doing a calculation you might choose to lay it out like we have done here however when you're using t accounts you would show it like this cash is an asset that's the a in dealer so debits increase it and credits decrease it like i said before debits are on the left and credits are on the right the final balance is still 35 dollars it is a different way to present the exact same information the benefit being that it is easy to distinguish between all of the different debits and credits in this case your closing balance goes on the left hand side because it happens to be bigger than zero however if your supplies had instead cost 65 then you would be left with negative cash or an overdraft of five dollars so your closing balance would go on the right hand side instead now you might be thinking why is all this necessary i can already tell from that little calc that i did there well this is a simple example for demonstration purposes in reality t-accounts are way bigger than this splitting out debits and credits allows us to spot things quickly in the general ledger if you're new to accounting it can be helpful to jot down t accounts as you're working through a problem to help you visualize this all in your head eventually you might not need to do this anymore because your brain can just naturally process this but it takes a bit of practice to get there okay so now i have another term for you and we touched on this one last week double entry bookkeeping this means that every accounting entry has an opposite corresponding entry in a different account in the context of t accounts this means that to record a transaction you will need to write down both sides of it in at least two t accounts you might want to pause the video now and grab a tea or a coffee or something to get in the zone for this next bit because i'm about to take you through some examples of double entry bookkeeping with t accounts okay let's get to it now you might be wondering why i was cleaning those windows at the start of this video well i've recently started my own window cleaning business i'm going to take you through some of those transactions that took place in the first month of operation first of all i the business owner invested 100 of my own money into this window cleaning business and in return the business issued me a hundred dollars in stock then the business decided to take out a further 200 loan from the bank to fund its activities soon after receiving the bank loan the business spent thirty dollars in cash on window cleaning equipment next it spent a further fifty dollars on cleaning supplies the supplier offers 30 day terms so the payment was made on account finally the business gets its first client and makes a hundred and fifty dollars cleaning their windows but in doing so it uses half of its cleaning supplies the first transaction affects two accounts cash and stock so we will need t accounts for both of these categories cash is an asset like i mentioned earlier it's the a in dealer so debits increase it i therefore need to put a hundred dollars on the left hand side of the cash t account since debits always go on the left stock is a form of equity which represents the second e in dealer so credits increase it credits always go on the right so we will need to put a hundred dollars on the right hand side of our new stock t account moving on in the second transaction a business takes out a 200 loan from the bank to fund its activities this transaction affects cash and loans payable which both need to increase by two hundred dollars we already have a cash t account so now we'll be needing another one for loans payable the cash part here is straightforward since we've done this already we need to debit cash a further two hundred dollars loans payable is a form of liability the l in dealer so credits increase it the 200 increase in our loans payable is recorded in our t account by adding it to the right hand side in transaction number three the business spends thirty dollars of its cash on window cleaning equipment so we need to credit cash by thirty dollars to decrease it and debit our new equipment t account by thirty dollars we record the credit to cash by adding 30 to the right hand side of the cash t account since credits always go on the right equipment is another form of asset so the debit to the equipment goes on the left hand side next our business spends further 50 on cleaning supplies which it pays for on account paying for something on account means that you agree to pay the supplier at a later date so for now you need to hold on to that cash but you need to recognize a liability since you owe the supplier for the goods they sold you supplies are a form of asset so we need to create a new t-account for supplies and debit the left-hand side of it by fifty dollars we owe fifty dollars to the supplier so we need another t account for accounts payable accounts payable is a liability the l in dealer so we need to credit the right hand side of the key account by 50 is your head hurting yet we only have one transaction to go so it'll all be over soon in our last transaction the business gets its first client and makes a hundred and fifty dollars cleaning their windows using half of its supplies in the process this one is a bit more tricky because there are two sides to it but don't worry we'll work through it together first we need to recognize our revenue we made a hundred and fifty dollars cleaning the clients windows so revenue needs to go up by 150 dollars and so does our cash revenue is the r in dealer so credits increase it we need to make a new revenue t account and credit it by 150 on the right hand side the cash we have made is recorded as and fifty dollar debit to the left hand side of the cash t account now there's one more thing we need to take note of and then our work is done we said half of our cleaning supplies were used up on this job so we can't recognize them as an asset anymore they now make up our cost of sales which is a type of expense expense is the first e in dealer so debits increase it in our fourth transaction we spent fifty dollars on supplies so if we have used half then we need to credit supplies by 25 to decrease them and debit our brand new cost of sales t account by 25 to increase it there we have it our first month of transactions all laid out visually in front of us in t accounts with debits on the left and credits on the right so there you have it an account is a place where we can record sort and store all financial transactions a t-account is a graphical representation of an account the general ledger is a place where a business stores a complete record of all of its financial transactions and accounts debits on the left credits on the right and finally double entry bookkeeping means that every financial transaction affects at least two accounts what are journal entries in the previous video i showed you that a t account is a visual representation of an account and how to record transactions using them however in day-to-day life t-accounts aren't that practical to use they take up lots of space and it's easy to miss a side of a transaction we need another more efficient method for recording our transactions but why is it important to record our transactions first you can use financial reports to measure the performance of your business to see if you're doing well or badly second it enables you to manage your cash flow so that you don't run out of it third it's helpful to keep things organized it's also useful at tax time to avoid missing out on any deductions and finally if your business were to get audited it's handy to have that paperwork ready in fact the process of recording all financial transactions is so important that we have a word for it bookkeeping bookkeeping can be done on any budget no matter how big your business is here are a few examples of some different accounting software packages that you can use on different budgets i will throw the links to a few of these in the description below now that we know why bookkeeping is important we need a method to record transactions earlier i said that t accounts are impractical so we're going to have to try out something else journal entries so what are journal entries a journal entry or je when abbreviated is a record of a financial transaction and it looks like this first we have the journal number this is a unique reference number that is used to identify the journal then there is the journal entry date this is the date that the journal is posted in the general ledger it's important because it affects the accounting period that the transaction is going to show up in next we have the names of the accounts that are impacted by the journal in this case cash and owner's equity notice that owner's equity is indented we indent the name of the account that is getting credited so that it is easier to see then we have separate columns for all of the debit and credit entries and finally there is the journal description below it's good practice to give a solid explanation here since you may need to refer back to the journal in the future and a good description will make it much easier to remind yourself why you entered it in the first place remember we're talking double entry bookkeeping so there must be at least two sides to the journal and the totals of those debit and credit columns must match each other exactly because the accounting equation always balances if you're using accounting software like quickbooks or any of those other ones that i mentioned to you previously it usually won't let you post the journal unless the debits and credits match each other exactly since this is a key control however if you're using sheets or excel then you're on your own and you'll need to watch out for this there are two types of journal automatic journals and manual journals automatic journals only exist when you're using accounting software these can save you loads of time by posting automatically behind the scenes as you enter invoices and receive payments on the other hand manual journals are typically only used for adjusting entries and unique transactions you need to fill out all of the fields in a template like the one i showed you earlier by yourself right i think it's time for that example that i promised at the start in last week's video i started my own window cleaning business it's been up and running for a week now and it's going well but my equipment is getting all gross and dirty so i need to go get it cleaned i take it to the laundry and they charge me twenty dollars i pay them in cash in order to do this we're going to need one of those journal templates first we need a unique journal entry number so that we can identify this transaction we discussed our first five transactions in the previous video so let's call this one number six the journal entry date should be today the 21st of september since that is when the equipment was cleaned so this transaction is going to show up in the september accounting period next we need the account names that are impacted by this journal in this case we're talking laundry costs and cash laundry costs are an expense that's the first e in dealer so debits increase it they charge me 20 so i need to put this number in the debit column cash is an asset that's the a in dealer so credits decrease it we need to indent the account description for cash to help us identify it as a credit and we're going to need to put 20 in the credit column finally we need to give this journal a description let's call it laundry costs week one great so now that journal is all prepped up it's ready to be posted in the general ledger our work here is done let's recap what we just learned there bookkeeping is the recording of all financial transactions in a business a journal is a record of a financial transaction the totals of the debit and credit columns always match automatic journals are used in accounting software to save you time and finally manual journals are used for adjusting entries and unique transactions what is an invoice a normal business transaction involves two parties a buyer and a seller the seller provides goods or services to the buyer and in return they want to get paid this is a transaction so that's the whole point so the buyer owes money to the seller but how much exactly and what specifically are they paying for and how long do they have to make the payment to answer all of these questions the seller sends them an invoice which sets out all of this information so the buyer knows what they owe they've got an itemized list of all of the goods and services that they're paying for and they know the terms of the transaction they're happy so they send the money to the supplier and the transaction's complete i've got bills i've got to pay bills and invoices are actually the same thing they relate to the document that is sent to the buyer to request the payment for the goods and services that have been provided by the seller great so now i've got a feel for invoices are but why are they important well for starters and we've touched on this already sellers want to get paid so it's important to them that invoices are sent out as early as possible so they're not waiting around for that cash the government is also keen on invoices most countries charge some form of sales tax on transactions involving taxable goods and services gst vat state or provincial tax you might have heard of some of these an invoice is a record of a transaction that splits out and identifies the sales tax so they're actually required by law for transactions involving registered businesses if you'd like to know the specifics then i recommend you check out your local tax authority's website from an accounting point of view invoices are also important because they trigger the accounting entries and the books of both the buyer and the seller they're used to track accounts receivable and accounts payable so we know what invoices are and we know that they're important but what do they actually look like let's create one and find out there are plenty of ways to make invoices google sheets actually has a built-in invoice template if you need to fire one off quickly but if you want to be more organized and have the ability to track payments and make reports then i recommend you use some sort of cloud accounting software like quickbooks online xero or freshbooks i'll link to all of these down below here we've got an invoice that i've thrown together using the sample company from quickbooks online this is a very typical invoice layout so it's a great place for us to start and run through all of the key features first of all we've got the names and addresses of both the buyer and the seller who's this transaction between well in this example we've got craig's design and landscaping services selling to cool cars and on the other side we've got the invoice number 1038 this is a unique number that identifies the invoice usually invoice numbers are sequential so the next invoice raised by this company would most likely be 1039. below that we have the invoice date in this case it's the 17th of jan this is the day that the invoice was created and it's critical to include it because it starts the countdown for when the payment is due from the buyer and how long have they got well that's determined by the sale terms which in this case is net 30 days so the whole payment is due within 30 days of the invoice date that's a common wait time but terms can vary depending on what's been agreed 30 days after the 17th of jan is the 16th of feb which is the due date that we can also see here next we have the description of the goods and services that this invoice relates to in this case it appears to be some kind of custom design work it's best to be as specific as possible in the invoice description because you don't want to cause any confusion and delay that payment to the right of the description we have the quantity rate and amount here the service has been provided just once and the amount per unit was for 350 dollars so in this case both the amount and the subtotal are for 350 below that we've tacked on a sales tax of 8 because the taxable service has been provided that comes out at 28 and that leaves us with an invoice total inclusive of tax of 378 dollars before we wrap up this video i'd like to answer four common questions that people tend to have when it comes to invoices question one when should i invoice invoices are most commonly sent out after the goods and services have been provided however they can also get sent out before depending on what's been agreed between the two parties however the accounting treatment in each situation is different question two are invoices and sales receipts the same thing the short answer is no however this is confusing because there are a few similarities both serve as evidence of a transaction and both are produced by the seller and given to the buyer however the key difference is that an invoice is a request for a payment so it's issued before the payments be made whereas a receipt that's issued after question three what's the difference between a sales invoice and a supplier or a purchase invoice well they're actually the same thing they're both invoices the difference in their names depends on your perspective if you're the seller then you call it the sales invoice and if you're the buyer you'd call it a supplier or a purchase invoice finally question four is an invoice legally binding in general no they're not an invoice by itself isn't legally binding if they were then what would stop you from just making all the money by just firing out invoices to whoever you want in order for them to become legally binding both the buyer and the seller have to agree on the terms i can't speak for the specifics of your country but in general it's important that both sides have evidence of the agreement at least an email or better yet in a signed contract you don't want to be that person that gets in a situation where the client or customer is refusing to pay oh no we wouldn't want that at all i mentioned that the three main types of account in a balance sheet are assets liabilities and equity let's break down what each of these really mean starting with assets what are assets assets are one of the three pillars of the accounting equation alongside liabilities and equity they're hugely important because they're what businesses use to operate and generate a profit in this video i'll break down the accounting definition of assets for you and take you through some of the common types that exist in most businesses we accountants we like to split assets apart into different categories like current non-current tangible or intangible don't forget to watch this video through until the end because you'll discover what all of these terms mean let's go i think most of us have kind of a preconceived idea of what an asset is we think of an asset as something that we own that's useful or has value something along those lines and that's not far from the truth although the definition of assets in accounting is a bit more specific assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events say what i know what on earth does that mean let's break the definition down and try to make some sense of it the first word that stands out to me is probable assets are probable future economic benefits the word probable carries with it a degree of uncertainty and i want to emphasize this because i think that often we take numbers for granted without questioning them the reality is that the future is uncertain and a lot of the time we accountants have to make estimates let me give you an example if you're running a business and you've got 10 clients who all owe you money can you say hand on heart that you'll receive back every penny every penny it's not uncommon for customers to go bankrupt or to dispute invoices after the work is done so what accountants do in these situations is make an allowance for doubtful debts we estimate what might not be recovered and expense it to provide for situations where there's uncertainty and that brings me on to the next part of the definition assets are probable future economic benefits what are future economic benefits these are the things that bring value to you or your business either directly or indirectly valuing assets based on future economic benefit means that we can't simply hold them in the books the value that they originally cost us imagine you buy a laptop today and you plan on keeping it and using it entirely for work will that same laptop carry the same future economic benefits in five years time probably not it might well have cacked it by then and not be worth anything anymore it can be hard to measure the lifespan of a laptop so instead we assume that all laptops have a useful economic life of say five years useful economic life is a term that you'll hear often when talking about assets it's how long an asset will remain useful to you and it's different to an assets actual life because useful economic life is an estimate so if that laptop cost you one thousand dollars today and we assumed a useful economic life of five years then we would depreciate or reduce its value by two hundred dollars a year for the next five years until it's worth nothing at all is this an exact science no clearly not but estimates like this are used every day to simplify scenarios and help accountants value assets lastly i want to bring your attention to another part of the definition assets are probable future economic benefits obtained or controlled by a particular entity as the result of past transactions or events obtained or controlled this highlights another important concept that we use in accounting called substance over form this means that when preparing financial statements we prioritize the economic substance of transactions over their legal form an example of this is when a business rents a building for a long period of time say 60 years and that building's remaining useful economic life is 65 years although the business is considered lessee and technically doesn't own the building the economic reality of the situation is that basically they do make sense because they have the right to use it for the majority of its remaining useful economic life following this principle of substance over form we can account for this building as an asset even though legally it isn't that has big implications for the accounting and tax treatment of the building now i'm oversimplifying this situation there are a few other factors to consider when making this call but that's the gist of it okay so now we know what an asset is let's run through some examples of common assets that you should know about but first and bear with me here a balance sheet is a snapshot of a business's assets liabilities and equity at a single point in time in the asset section of a balance sheet we list out all of the different types of assets that a business owns or controls these assets are often arranged in order of liquidity but what is liquidity you can think of it as how quickly you can turn an asset into cash and following that vein of thought assets in the balance sheet can be divided into two distinct categories current assets and non-current assets current assets are the ones that we can convert into cash in a short period of time typically within a year the three types of current assets that show up most often are cash accounts receivable and inventory inventory is your physical stock or the goods that you intend to sell to make a profit when your business sells inventory your customers owe you money which we call accounts receivable and when your customers actually pay you your accounts receivable turn into cash the most liquid asset of them all other current assets include prepayments and short term investments you can think of prepayments as situations when you're paying for something in advance rent is a good example because most of us pay rent at the start of the month at the moment that rental payment is made we need to recognize a prepayment as an asset in the balance sheet it's an asset even though we aren't going to convert it into cash because we're going to get some of that sweet sweet future economic benefit out of it remember the definition not all assets convert into cash short-term investments can be made when your business has cash to spare you might choose to put some of that money to work by investing it in stocks and shares this investment is considered to be a short-term investment or current asset if you're in it for the short game and you plan to sell those stocks or shares within a year's time however if you want to hold on to them for longer than a year they become non-current assets instead non-current assets are long-term assets that are used in operations to generate profits and that can't easily be converted into cash there are three main categories of non-current asset the first which we touched on a moment ago are long-term investments these are the investments that we plan to hold on to for longer than a year the other two categories from non-current assets are tangible or intangible assets tangible or fixed assets the ones that have an actual physical presence you can actually touch them the most common types are land and buildings or ppe which stands for property plant and equipment these include things like furniture machinery and cars but not all assets have a physical presence we call those that don't intangible assets intangible assets include things like intellectual property patents royalty rights trademarks and copyright if you're a photographer then you might own the royalty rights to some of your own photos if a company wants to use one of your images for their website or blog they should pay you a royalty fee to recognize your work so this intellectual property that you own is bringing you probable future economic benefits you should be an asset right the answer is sometimes the thing with intangible assets is that they can be very difficult to value how can you calculate the future economic value of your own licensed photos you can't really so most of the time businesses don't capitalize intangible assets that they've generated internally what does capitalize mean when we capitalize something we record it as an asset in the balance sheet as opposed to expensing it in the income statement we only capitalize intangible assets that we've purchased from someone else and these are held at the cost value that we paid for those assets or a lower amount because we amortize intangible assets to decrease their value over time much like we depreciate fixed assets an intangible asset that doesn't fit into the category of intellectual property is good will goodwill is the amount that one company is prepared to pay for another over and above the fair value of its net assets when facebook bought instagram back in 2012 for something stupid like a billion dollars where instagrams and their assets at the time worth that much not by a long shot the majority of that purchase was for goodwill that's the premium that facebook were happy to pay for instagram's brand and potential future earnings over and above the fair value of their net assets what are liabilities assets are equal to liabilities plus equity liabilities can be broken down broadly into three categories current liabilities non-current liabilities and contingent liabilities we'll explore the meaning of all of these terms in this video and i don't know why but the word liabilities always makes them seem like a bad thing like something we want to avoid but that is not the case liabilities are just a normal part of business they aren't anything to be afraid of and i'm going to explain why right now hold on tight because you're about to hear the full accounting definition of liabilities and aim pretty liability is a probable future sacrifices of economic benefits arising from present obligations of a particular entity to transfer assets or provide services to other entities in the future as a result of past transactions or events what the i thought the assets definition was bad but this is something else let's break it down and see if we can make any sense of it liabilities are probable future sacrifices of economic benefits the word probable hints at uncertainty when dealing with liabilities we accountants often have to use our own judgment of situations to estimate future outcomes this is especially the case with accruals which i'll get into later in this video future sacrifices means that we're going to need to give up something in the future and what are we going to give up economic benefits which relates to the things that have value or more specifically assets and services and that doesn't only mean cash this definition also says that liabilities are present obligations resulting from past transactions or events so in order to recognize a liability the transaction or event that is committing us to transferring assets or providing services must have happened already yikes are you still there i hope i haven't lost you yet it's important to understand what liabilities are because they're a crucial part of normal business a simpler way to think of liabilities is that they are a source of third-party funding that a business uses to buy assets and fund operations if we bring that accounting equation back up then we can see that businesses have two broad financing options to choose from when buying assets liabilities and equity does that make sense i think things might become clearer with some examples let's find out now that we've got a feel for what liabilities are let's talk through some of the common types of liability that are worth knowing about to get a summary of a business's liabilities we can take a look at its balance sheet a balance sheet is basically a snapshot of a businesses assets liabilities and equity at a single point in time in the liabilities section of the balance sheet we list out all of our different liabilities typically these categories are arranged in order of their due date with the short-term liabilities at the top of the list and the longer-term liabilities further down short-term liabilities or what we accountables like to call current liabilities are a business's obligations that need to be settled within one year from now the most common type of liability is accounts payable accounts payable relate to the bills or invoices that we get sent when buying something from the supplier on credit but why would a business want to buy something on credit and for that matter what does credit even mean buying something on credit means that you're agreeing to pay later or if your head works like an accountant you're making a present obligation to transfer assets or provide services to another entity in the future in a standard business transaction we have two parties a buyer and a seller the seller provides the buyer with a product or a service along with an invoice or a bill and in return the buyer sends them cash to settle the payment however sellers sometimes like to incentivize buyers to spend more money and bring their purchases forward by offering them credit terms picture a restaurant buying some ingredients from a food wholesaler one day the restaurant realizes that they've run out of carrots a vital ingredient of their award-winning minestrone soup it's friday morning and they're stressing out about it because it's going to be a busy night and to make things worse they're running low on cash larry the restaurant owner does the local food wholesaler and says hey mate look we're badly in need of some carrots but the issue is i'm a bit strapped for cash right now larry don't sweat it you're our best customer we'll have those carrots delivered to you right now and don't worry about the cash we know you're good for it we'll add 30 day credit terms to your invoice you legend i knew i could count on you the seller despite the risk of reduced cash flow has offered larry one month credit terms which they note down in the invoice this suits larry well because he likes to buy things on credit having a one month grace period gives him flexibility to manage his cash flow did you hear that the countdown starts when they received the invoice and in 30 days they made the payment transaction complete from an accounting point of view when the buyer receives the invoice from the supplier they recognize an account's payable balance for the amount that they owe and on the other side of the transaction the seller recognizes an equal and opposite accounts receivable balance for the same amount one person's accounts payable is another's accounts receivable another kind of current liability is salaries payable most businesses employ staff that they need to pay obviously when does that payment usually happen well it depends but often it's at the end of the month so when the books are prepared at the end of the month we need to recognize a balance for salaries payable businesses also have to pay tax on the profits they generate so they need to recognize taxes payable on their balance sheet as well next there's interest payable so you might have noticed by now that most current liabilities include the word payable which makes them easy to identify but that's not always the case accruals or accrued expenses are adjusting journal entries typically posted by accountants a month end to recognize expenses that have been incurred but haven't been recognized yet in the books let's refer back to larry the restaurant is fast approaching month end so larry gives his accountant a call hey buddy would you mind getting our books up to date i'd like to check our performance for this month of course are there any accruals i need to post yeah we had a plumber in last week to fix the dishwasher and i don't think they've sent us an invoice yet ah right you are what did they quote he didn't say but last time it was 500 for a similar job in this situation the restaurant has incurred an expense during the current month because the plumber has provided them with a service however they haven't received an invoice so the liability and the expense haven't been recorded in the books yet so larry's accountant posts an accrual in the books to recognize an accrued liability and an expense of 500 this is an estimate because there's no supporting invoice to match the transaction to but by recording this transaction larry's accountant is ensuring that the business's income statement and balance sheet will give an accurate picture of the restaurant's financial performance when larry comes to review it the crawls are probably worthy of a whole video by themselves if you'd like to hear more about them let me know down in the comments below geez we've got a lot of current liabilities here and that isn't even all of them two other big ones that i haven't even mentioned yet are unearned revenue and short-term loans you can think of unearned revenue as the opposite of a prepayment they come up when someone pays you for a good or service in advance now that might sound like an asset and you're right cash is an asset but we're double entry book keeping so there's another side to the transaction in this case it's unearned revenue which is a liability because you have an obligation to transfer assets or provide a service in the future short-term loans are exactly what it says on the tin they are loans that need to be settled within one year from today but short-term loans can also refer to the current portion of long-term loans which are non-current liabilities non-current liabilities are obligations that aren't expected to be settled within a year there are many types of non-current liability i'm going to mention a few now but i'm not going to get into the nitty-gritty because this video could go on all day and who's got time for that when a business wants to raise money from outside to fund its operations or invest in new assets it has a couple of options it could seek a long-term loan from a bank or financial institution who in return will expect to be repaid with interest alternatively the business could choose to issue bonds instead bonds are similar to loans but the key difference is that the money is raised directly from the public you can think of them as formal iou notes you'll still be charged interest although it may be cheaper than getting a loan from a bank the flip side however is that bonds are less flexible other non-current liabilities that i think we've all heard of are mortgages on properties and employee pensions and a lesser-known one is deferred income tax which is definitely for another day but you can think of it as a byproduct of the timing differences between your accounting and taxable profits that wraps up current and non-current liabilities but i mentioned earlier that there's a third category contingent liabilities these are less common than the other two but nevertheless it's worth being aware of them a contingent liability is a potential obligation that may arise depending on the outcome of an uncertain future event it can be risky to ignore contingent liabilities because the outcomes can be serious let me explain our favorite restaurant owner larry has a problem one of his customers slipped and fell in the restaurant and broke their wrist they're suing the restaurant for damages because there was no wet floor sign if the outcome of the litigation is probable and can be reasonably estimated then the contingent liability should be recorded as a loss in the income statement and a liability in the balance sheet however if the outcome is only considered to be possible or remote then the liability might only need to be noted in the footnotes of the restaurant's financial statements or not even disclosed at all management need to make a judgment of whether the outcome is going to be probable possible or remote and that decision will influence the accounting treatment of the contingent liability what is equity equity is the oddball in the accounting equation and there are so many different terms and jargon that come with it as part of the parcel wow so many and this isn't even all of them but i've cherry picked these ones to teach you today because if you can understand these then you'll have a solid grasp of what equity means and to be honest you'll be far ahead of most of the other people out there who are still battling with this topic oh and by the way if my voice sounds funny today it's because i've been struck down by the man flu we've had a chilly week in vancouver and it's finally got to me but anyways are you ready let's do this at the start of this video i promised you two definitions of equity in accounting and here's the first equity is the residual value of an entity's assets after deducting all its liabilities uh that's it hold on i'll explain how this works first let's bring up the accounting equation again you'll be seeing this quite often in this video and it'll become clear why later on assets are equal to liabilities plus equity if we rearrange this formula then we can see that equity is made up of assets minus liabilities now we accountants have another word to describe assets minus liabilities net assets i said a moment ago that equity is the residual value of an entity's assets after deducting all its liabilities residual value basically means what's left over after you take all of an entity's assets and deduct its liabilities in other words what we've got here equity represents the net assets of a business simple hey yes it looks simple but what does it actually mean definition number two is gonna help us shed some light on this it says that equity represents the net funds invested into a business by its owners i like this description of equity because it gives us some context let me explain with the help of the accounting equation on the broader scale there are two ways that funds can be invested into a business to finance its operations and you're currently looking at both of them it could choose to borrow money from third-party lenders like banks which in essence are liabilities or it could choose to use the net funds invested into the business by its owners in other words it could choose equity so now we know that equity represents the net assets of a business and at the same time it represents the net funds invested into the business by its owners so what we're saying here is that the owners of a business own or have a claim on all of its net assets and we call this equity make sense now that we've got an idea of what equity means let's have a look and see what it's actually made of full disclosure here equity is made up of a lot of things and some parts are a bit complicated but i mentioned at the start that i've cherry picked the parts that i think are most important that will give you the most value three in particular that together will give you a solid understanding of what equity is and i'll share them with you in a moment but first i think it'll be easier for you to picture all of this if we work with an example imagine that you've got an idea for a business you've been following the plastic free feb movement on the internet and you've come across this video ninety percent of all you realize that plastic makes up 90 of all ocean debris so you come up with an idea to decrease the number of plastic bags by developing your own reusable shopping bag to help save the planet but there's a problem you have a choice to make that all startup businesses end up facing how to structure your business you could choose to go it alone become a sole proprietor and avoid incorporating the business as a separate legal entity you could go in 50 50 with a mate and form a partnership or you could decide to create your own corporation a separate legal entity that's owned by its shareholders now there are pros and cons to each of these but that's for another day let me know down in the comments if you'd like to hear more about it i want us to rewind for a second i said that equity is essentially made up of three things and the reason why i've laid all this out here is because the words we use to describe these three things changes depending on the structure of the entity and i think that's partly what makes equity seem so complicated there is so much different jargon that we use to describe what is essentially the same thing let me show you the first thing that makes our faculty is capital contributions capital relates to the funds raised to support a business and contributions simply mean that these are given to the business so capital contributions is the money that the owners invest into the business out of their own pockets now the way that we describe this changes depending on who the owners are and that changes based on the structure of the business if you're a sole proprietor then there's only one owner you so you'd call the money that came out of your own pocket owner's equity however if you were part of a partnership then the owners of the business would be the partners so you'd call the capital contributions partner contributions and if you created a separate legal entity a corporation then the owners of the business would be the shareholders and you'd call the funds invested shareholders equity so we have three different terms that describe basically the same thing capital contributions are one of the ways that businesses tend to fund themselves during the early startup phase before they become profitable imagine that you choose to become a sole proprietor at least at first and you invest 1 000 of your own money into your reusable bag business what's your business's financial position let's bring up the accounting equation again your business has assets of one thousand dollars in the form of cash and you the owner have a claim of one thousand dollars on those assets which we call owner's equity the accounting equation is in balance as it should be because when we're looking at a snapshot of a businesses assets liabilities and equity at a single point in time we're looking at its balance sheet now capital contributions aren't the only thing making up equity when your business generates revenues or incurs expenses it'll make a profit or a loss which is just revenues less expenses what happens to that profit and who does it belong to you of course you're the owner so you could choose to reinvest these profits back into the business or hold on to them to use in the future over time these profits and losses that you're holding on to build up and we call them retained earnings retained earnings are defined as accumulated profits held for future use and thankfully this term stays the same regardless of whether you're a sole proprietor a partnership or a corporation your business's equity is made up of two things capital contributions and retained earnings over time your reusable bag business starts to make some real money so much in fact that you no longer need to dip into your own pocket to fund it using capital contributions you can cover all of the expenses using the accumulated profits that you've held onto and set aside your retained earnings within a year your business is booming you've got much more money coming in than what's going out in other words you've got a net cash inflow but back home all is not so rosy you've invested so much of your own savings into the business through capital contributions that you're running out of money to live on for yourself you need to withdraw some cash out of the business to cover your own personal expenses well how does that work retained earnings are made up of a couple of things remember i said that they're your accumulated profits held for future use so a big chunk of your retained earnings is your accumulated profits which are your revenues less your expenses which comes straight from your income statement an income statement is a financial report that you use to track your revenues and expenses over a period of time but retained earnings are also made up of withdrawals the money that's taken out of the business and distributed to its owners we have different terms to describe withdrawals depending on the structure of your business for sole proprietors we call them drawings and for partnerships we call them partner drawings and for corporations we call them dividends which are profits distributed to the shareholders again we have three terms all used to describe what is essentially the same thing withdrawals as the sole proprietor of your reusable bag business you can use drawings to withdraw your accumulated profits for personal use this impacts the accounting equation by decreasing assets because the businesses cash has gone down and decreasing equity because your claim on those net assets has decreased hold on now i want to show you something interesting we've broken equity down into capital contributions retained earnings and withdrawals but let's see how this all fits together using the accounting equation earlier i said that when we look at a snapshot of the accounting equation at a single point in time we're looking at a balance sheet the balance sheet is made up of three things assets liabilities and equity and we know that equity is made up of capital contributions from the businesses owners and retained earnings which are its accumulated profits held for future use retained earnings break down further still into accumulated profits less withdrawals and accumulated profits are a businesses revenues less expenses which when looked at over a period of time make up its income statement so what we've got here is the expanded accounting equation and i like this because we can see how two of the businesses major financial statements the income statement and the balance sheet are linked together through equity there are two main methods of accounting the cash method and the accrual method in the next two videos i'll explain how each of these work so what is the cash method of accounting the cash basis of accounting is a method of recording financial transactions under this method transactions are only recorded once cash changes hands we record revenue only when cash is received and we record expenses only when cash is paid out let me elaborate on this with a simple example imagine you've got a baking business and a customer places an order for a birthday cake the ingredients for this cake cost you ten dollars to buy and you are selling it at a 150 percent markup on cost so the customer pays you 25 you've got two transactions to record first you need to record the expense which in this case is the cost of buying the ingredients for the cake you debit your expenses by ten dollars to increase them and you credit your cash by ten dollars to reduce your cash balance you then need to recognize your revenue which is the twenty five dollars that the customer pays you you debit your cash by twenty five dollars to increase it and you credit your revenue by twenty five dollars to increase it as well if you're new to davidson credits or you'd like a refresher i recommend that you check out this video now i want you to consider two scenarios the first is that you buy the ingredients for your cake you bake it and you sell it all the same day on the 25th of october the customer pays you in cash under the cash basis of accounting transactions are recorded when money changes hands so in this case you record your expense and your revenue on the same day the 25th of october the second scenario is the same as the first except this time the customer pays on account your business has seven day payment terms so you receive the cash a week after you baked and handed over the cake to the customer under the cash basis of accounting you record your expense the day that you bought the ingredients for your cake and you recognize your revenue the following week on the 1st of november because that's when you received the cash from the customer so what are the pros of using this method for one it's a great way to record transactions small businesses that deal and operate mainly in cash it's simple and easy to understand so your business doesn't necessarily need to hire an accountant or someone that understands more complex accounting methods that makes it cheap to maintain and you might be able to get away without paying for more pricey accounting software and finally many countries accept this method of accounting for tax purposes so long as your earnings are below a certain threshold so this could be a viable option for you now you might be thinking wow this sounds amazing why doesn't everyone do it well in reality most businesses are much too complex to use this method of accounting when you cash account you don't have an accurate way of recording your profits so there can be huge fluctuations in your results this is caused by recording income and expenses in separate accounting periods if we go back to that second scenario we can see that we recorded the expense in october and the revenue in november so the october accounting period would show a loss of 10 and the november accounting period would show a profit of 25 it would make much more sense to show a profit of 15 in october because that's when the work was done in addition to this you have no way of knowing your financial position because you aren't recording your payables and receivables finally and this can be a clincher the cash basis of accounting isn't allowed under gaap or ifrs so if you follow either of these principles or standards then no dice [Music] so the cash basis of accounting can be a great way to record transactions if you've got a small business that relies solely on cash however if your business has payables and receivables this method probably won't work well for you because timing differences between cash in and cash out mean you don't have a reliable way of recording your profit if that's you then you'll need to use the accruals basis of accounting instead to match up those revenues and expenses i'll take you through this method in the next episode of accounting stuff what is the accrual method of accounting hey guys welcome back to accounting stuff the place where we discuss all things accounting up until now we've been talking about some basic accounting theory last week we talked about the cash basis of accounting and this week we're going to talk about another super important method of accounting the accrual basis of accounting the accrual spaces of accounting is considered to be a much better method to follow than the cash basis because there's so much information you can extract from it i'm going to explain why most businesses when they're starting out tend to cash account because it's easy but have you ever wondered how the big companies like apple amazon and google do their books or pretty much any household name they all have one thing in common they use the accruals basis of accounting if you've never heard of it before don't worry i'm going to explain it all to you right now don't forget to stick around to the end because i'm going to talk through some of the main advantages of using this method and also the reasons why most businesses starting out tend not to use it let's get cracking in the last video i explained the pros and cons of the cash basis of accounting if you missed it there should be a link somewhere up here with the cash basis you record your revenue once you receive the cash and you record your expenses when you pay that cash back out it's a great way to do your books and it's simple and that's the reason why it's an approach used by many small businesses and individuals for personal finance however there is one big problem with this accounting method it can be really hard to work out your business's profitability particularly when you want to work out how much profit you made for one particular point in time like one month of the year for instance and that's because of the timely differences between when you recognize your revenue and expenses i'll give you an example of this in a moment the accruals basis of accounting solves this issue revenue is recognized as it's earned and expenses are recorded as they are incurred it's a way of recording the substance of transactions and that makes it a much much easier way to record the performance of your business over a specific period of time let me explain let's go back to that example of a baking business selling a cake that we discussed in the previous video the ingredients of that cake cost us ten dollars to buy and we sold it for 25 that leaves us with a profit of 15 now let's imagine a scenario where we sell a cake to a customer on the 25th of october the customer has seven day payment terms so we don't receive the cash until the 1st of november under the cash basis of accounting the revenue would be recognized on the 1st of november because that's when we receive the cash however under the accruals basis of accounting the revenue would be recognized on the 25th of october because that's when the substance of the transaction occurred that's when we physically handed over the cake to the customer now let's also imagine that we baked that cake using ingredients that we purchased a month ago in september under the cash basis of accounting we would have recorded the expense in september because that's when we paid the cash for the ingredients however using the accruals basis of accounting we would instead record that expense in october because that's when we sold the cake you can see that under the cash basis of accounting we recorded a loss of 10 in september and a profit of 25 in november this timing difference that you can see here could cause us a real headache if we wanted to look back in time and review our performance in october because we wouldn't see any profit there it might not seem that complicated for this one example but imagine that we'd sold 100 cakes and they all had timing differences just like this one it would be a nightmare to work out our profitability for a particular period in time because we didn't record the substance of the transactions as they were incurred however the accruals basis of accounting neatly solves this issue for us we record both the revenue and expense in october so we can see the profit of 15 in october just like you'd expect our revenues and expenses are aligned with each other in the same accounting period because in the accruals basis of accounting we apply the matching principle the matching principle simply states that revenue and all expenses incurred in order to generate that revenue need to be recognized in the same accounting period this is a key differentiator between the cash and accrual methods of accounting the matching principle makes it easier for us to objectively analyze results because you can accurately measure your profit over time now that we've clarified the accruals basis of accounting let's run through some of its pros and cons first of all like i just said it applies the matching principle so businesses profitability can be accurately measured for specific time periods it also measures accounts receivable and payable so you can build a picture of your financial position and is accepted under gaap and ifrs so it's possible to produce financial statements under these principles and standards on the other app on the other hand however the accruals basis of accounting doesn't explicitly track cash flow so this needs to be calculated separately using the direct or indirect method it's also more complicated than the cash method of accounting because you have to make estimates and assumptions this can be unsuitable for small businesses hence why many of them choose to adopt the cash method of accounting instead if you're deciding which of these methods to use for your business then you'll need to weigh up the pros and cons of each in order to come to a decision both of these methods are usually allowed for tax purposes although the cash basis is normally only an option if your revenues are below a certain threshold you can google what that threshold is on your tax authority's website it's also important to know that whichever method you choose could impact your tax payments by bringing them forwards or backwards depending on your situation however in the long run both the cash and accruals methods tend to produce the same result most startups and small businesses tend to start off with the cash method of accounting because it's easier to apply and it's a good way to track cash flow however if and when those businesses continue to grow there may come a point where it makes sense to make the switch to the accruals basis of accounting instead what is the revenue recognition principle to kick things off let's define revenue revenue is the income earned from the sale of goods or the provision of services the sale of goods could relate to a baking business selling a cake and the provision of services could be a car wash cleaning your car so now that we've clarified that what's the revenue recognition principle [Music] the revenue recognition principle states that revenue is recognized when it's earned not when cash is received let me show you what i mean i want you to imagine two scenarios in the first a customer orders a cake from a bakery and pays in advance in november they receive the cake the following month in december under the revenue recognition principle revenue is recognized when it's earned not when cash is received so in this case the bakery recognizes its revenue not in november but in december because that's when the revenue was earned that's when the cake changes hands in accounting we call this kind of income deferred revenue because the payment is made in advance for goods that are to be delivered in the future in the second scenario a customer gets their car washed in december they pay for the service on account with 30 day payment terms which means they hand over the cash in january under the revenue recognition principle the revenue is recognized in december because that's when the service was provided that's when the car wash took place in this case we called the revenue accrued revenue because the service was provided in advance of the payment now it's important to know that accrued and deferred revenue don't exist under the cash basis of accounting because under that method revenue is only recognized once cash changes hands what's the relationship between inventory and cost of goods sold today i want to focus on inventory in a merchandising business specifically how inventory in the balance sheet interacts with the cost of goods sold and revenue accounts in the income statement this can be a bit confusing so i recommend you watch this video all the way through to the end so you get the complete picture there are two main types of business that hold inventory manufacturing businesses and merchandising businesses manufacturing businesses buy raw materials which they make into finished goods that they then sell to earn revenue whereas merchandising businesses do things slightly differently they buy goods that they resell to earn revenue okay so with that in mind what is inventory well in a manufacturing business inventory is the raw materials work in progress and finished goods held by business that it intends to sell to earn revenue however in a merchandising business inventory is the goods held by the business so you see the definition for inventory in a merchandising business is a bit simpler manufacturing businesses hold three different types of inventory raw materials work in progress and finished goods whereas merchandising businesses only have one type of inventory goods for good to be treated as inventory a merchandising business must hold on to it and it must plan to sell it in the future in order to earn revenue this future economic benefit is the characteristic that makes inventory an asset actually inventory is normally thought of as a current asset because most businesses intend to turn their inventory into cash within one year but more on that soon let's imagine that you own a merchandising business you buy your inventory from a supplier and then you sell this inventory on to your end customer so what hats actually since i'm in canada and winter's just around the corner let's do twix instead so you've run a merchandising business that sells toques you buy your toots from your local manufacturer at four dollars a toque which you pay for in cash and you sell these twos on to your end customers at seven dollars your customers pay you on account how do you account for this well for each took that you sell there are two transactions to consider transaction one takes place when you buy the two from your supplier and transaction two happens when you sell that two con to your end customer to record these transactions you'll need to create some journal entries so what's the journal entry for transaction one you've bought a toque from your supplier for four dollars so you need to debit your inventory account to increase it by four dollars you debit inventory because inventory is a type of asset the a in dealer which makes it a normal debit account so debits increase it and credits decrease it if you haven't heard of dealer before it's a handy acronym that you can use to identify debit and credit accounts i've made a video explaining what it is in more detail which you can find up up here okay now where does the other side of this journal entry go you've bought something so you have two options you could credit cash or you could credit accounts payable in this example you paid for the two in cash so you credit your cash account to decrease it by four dollars cash is another kind of asset the a in dealer which makes it a normal debit account so you credit cash to decrease it great so here's your completed journal entry for transaction one debit inventory by four dollars and credit cash by four dollars but how does this journal entry affect your books well we can find that out using t accounts t accounts help us visualize the impact of transactions on your general ledger this journal entry affects 2t accounts cash and inventory these are both assets which are held in your business's balance sheet in t accounts debits always go on the left and credits always go on the right so you debit the left hand side of your inventory t account by four dollars and you credit the right hand side of your cash t account by four dollars okay i'm afraid that was the easy part in transaction two things become a little more complicated we need two journal entries to record this transaction oh and if you're finding it hard to remember all of this i've put together a one-page cheat sheet that summarizes all of the key areas in this video you can help support this channel by buying it on my website there should be a link to it up here in transaction 2 you need to recognize your revenue and record your cost of goods sold to recognize your revenue you need to credit your revenue account by seven dollars to increase it in your income statement revenue is the rn dealer a normal credit account so credits increase it and debits decrease it but where does the other side go well you've sold something so that means you need to debit cash or accounts receivable in this example the customer paid you on account that's like in iou they haven't actually paid you the money yet that means you need to debit accounts receivable to recognize the euro to seven dollars hold on to your horses we've got one more journal entry to do you need to release the cost of goods sold from your balance sheet to your income statement here's what i mean by that in transaction one you took up four dollars of inventory in your balance sheet this is your cost of goods when you sell the two to your customer you'll need to release this cost of goods from your balance sheet to your income statement but how do you do that well you credit your inventory account by four dollars to decrease it in your balance sheet and you debit your cost of goods sold account by four dollars to increase it in your income statement cost of goods sold is a type of expense the e in dealer a normal debit account so debits increase it and credits decrease it nice one so we've worked out both of your transaction two journal entries but how do these affect your books we're going to need some more t-accounts three more because as well as affecting cash and inventory these entries hit accounts receivable in your balance sheet along with revenue and cost of goods sold in your income statement to recognize your revenue you debited accounts receivable by seven dollars and credited revenue by seven dollars and to release your inventory or your cost of goods sold from your balance sheet you credited inventory by four dollars and debited cost of goods sold by four dollars what's nice about t accounts is that we can easily see the impact of these transactions on your books you're left with negative cash of four dollars an increase of seven dollars in accounts receivable and a net movement of nil in your inventory account you've also earned seven dollars of revenue and incurred four dollars of cost of goods sold these five t accounts make up a small section of your business's books which in turn are used to build financial statements like your balance sheet and your income statement the balance sheet gives you a snapshot of your assets liabilities and equity at a single point in time whereas the income statement summarizes your revenues and expenses over a period of time so now let's recap what went down a few moments ago but this time with the whole picture laid out in front of us in transaction one you bought a toque from your supplier you converted four dollars of cash in your balance sheet into another type of asset inventory at this point you're down four dollars in cash and you're holding four dollars of inventory in your balance sheet then in transaction two you sold to on to a customer this transaction impacted both your balance sheet and your income statement because you released this inventory from your balance sheet to cost of goods sold in your income statement and at the same time you recognized seven dollars of revenue in your income statement and increased your accounts receivable in the balance sheet by seven dollars as well that leaves you with negative four dollars of cash and seven dollars of accounts receivable in your balance sheet in your income statement you've earned a gross profit of three dollars we touched on this one earlier but i think it's worth repeating so here's my number one accounting hack this simple trick will help you to effortlessly identify and distinguish between debit and credit accounts and here it is dealer d-e-a-l-e-r dealer now if you're subscribed to my channel then you might have heard me mention this quite often dealer in dealer a and dealer the ian dealer dealer okay so quite often it's a bit of an understatement i actually use this all the time here's how it works [Music] dealer is an acronym that stands for dividends expenses assets liabilities equity and revenue alright so what does that mean well as a general rule in accounting debits always go on the left and credits always go on the right so how this works is that on the left hand side we have dividends expenses and assets representing normal debit accounts that means the debits increase these balances and credits decrease them on the right hand side we have liabilities equity and revenue these are normal credit accounts that means that credits increase them and debits decrease them d-e-a-l-e-r dealer this is it my secret weapon but before you click away i want to share one more knowledge bomb that'll help you understand the true meaning of debits and credits in accounting after all what use is a sword if you don't know how to wield it i think that's an expression anyway here it is every financial transaction involves a flow of economic benefit from a source to a destination credits represent the sources that economic benefit can flow from whereas debits represent the destinations that economic benefit can blow to what does any of this have to do with dealer i'll show you right now i want you to imagine that you own a business and your business holds some cash where could this cash have come from what are the possible sources well broadly speaking there are only three places you could have borrowed it from a third party like a bank you as the owner could have invested it into the business out of your own pocket or you could have earned that cash by selling a product or a service liabilities equity and revenue these are the three possible sources of economic benefit on the flip side what could your business spend this cash on well it could distribute it back to the owners of the business that would be you in this situation it could be used to pay your bills like your rent or employee's salaries or you could use it to buy new assets like a laptop to work on in other words dividends expenses and assets the three destinations of economic benefit time for some practice questions question one the owner of a car wash provides their company with a one thousand dollar initial investment is the entry to the company's cash account a a debit or b a credit the first thing to take note of is that cash is an asset that's the a in dealer now what's dealer here's a little cheat sheet that i made to help us out with these questions dealer is an easy way for us to remember the expanded accounting equation dividends plus expenses plus assets are equal to liabilities plus owner's equity plus revenue the left-hand side of this equation are normal debit accounts these increase when debited and decrease when credited on the right hand side we have the normal credit accounts these increase when credited and decrease when debited i just said that cash is the a alien dealer that makes an asset and those increase when debited and decrease when credited in this question the initial investment causes the company's cash to increase so the answer is a a debit question number two and this follows on from the first one is the entry to owner's equity a debit or a credit there are two ways we can go about solving this in method one we use dealer owners equity is the second e in dealer so we know that it's a normal credit account that means credits increase it and debits decrease it the owner of the car wash has invested one thousand dollars into the company so owner's equity must have increased by one thousand dollars so we credit owner's equity alternatively we could have used a second method that's a bit quicker we know that in double entry bookkeeping there are two equal and opposite sides to every financial transaction since we've already debited cash in question one we must have to credit owner's equity in order to keep things balanced in question three we're looking at a different transaction the car wash pays the supplier 200 in cash which account is debited is it a accounts payable or b cash if the car wash is paying a supplier in cash then that means their cash balance has to go down because they've paid it over to the supplier and their accounts payable has to go down too because they're reducing the amount of money they owe to the supplier accounts payable is a form of liability that's the ellen dealer which makes it a normal credit account so credits increase it and debits decrease it here we want to decrease accounts payable so the answer is a we've got to debit it in question four a customer gets their car washed for ten dollars they pay on account with 30 day payment terms which account is credited is it a revenue b cash or c accounts receivable here we can eliminate cash right away because this transaction doesn't involve cash the customer pays the car wash on account so they still owe the car wash ten dollars but they have 30 days in order to hand over the money because they've got 30 day credit terms so we are left with revenue or accounts receivable and this transaction represents a sale because a service has been provided to the customer and the revenue recognition principle tells us that we need to recognize this income now because revenue is recognized when it's earned not when cash changes hands revenue is the r in dealer so it's a normal credit account so credits increase it and debits decrease it here we need to increase revenue so we need to credit it question number five the following month the car wash receives the ten dollars from the customer which account is credited is it a revenue b cash or c accounts receivable right off the bat we can remove revenue because this transaction doesn't involve revenue we're still applying the revenue recognition principle so the revenue was recognized back when it was earned the previous month in question four so we're left with cash and accounts receivable cash is an asset which is the a in dealer so debits increase it and credits decrease it since the car wash has received cash cash needs to be debited to increase it that leaves us with accounts receivable in question four the customer owed the car wash ten dollars so the car wash needed to recognize an account receivable now that the car wash has received that ten dollars back that balance needs to be reduced down to nil accounts receivable are also a form of asset so debits increase it and credits decrease it here we want to reduce our accounts receivable balance so we need to credit it what we've covered so far mostly relates to steps one and two of the accounting cycle identifying transactions and preparing journal entries we post journal entries in step three into the general ledger so what is the general ledger i like to think of the general ledger as a database that stores a complete record of all your accounts and journal entries but don't worry if this doesn't make sense right away all would be revealed in this video first i think we should see where the general ledger fits in the big picture of accounting a little while ago i made a video on the accounting cycle which basically shows us how financial accounting works if you missed it i'll drop a link in the description but as you can see here we post the general ledger in step three right after identifying transactions and preparing journal entries and it's these three steps that we're going to focus on today i've got two example transactions for you and we're going to prepare the journal entries and post them to the general ledger in two different ways now let's take a step back for a moment and pretend that you make delicious tasty cheeses for a living now wouldn't that be the best your business is called let it bree and it's been in your family for generations back in the day when your grandparents were running the business they would have looked after let it breeze books using actual books because that's what ledgers were at the time books that you'd regularly record transactions in your grandparents were literally bookkeeping and they would have kept several different ledgers a cash book one for receivables inventory fixed assets maybe one for payables and so on and then they had the precious the general ledger which is where they stored a complete record of the businesses accounts and journal entries all of these smaller books are called subledgers they support the general ledger by providing extra detail for certain accounts more on that soon back then your grandparents would have filled out all these ledges by hand but today the books are gone now we've got computers we still hold on to some of the old words like bookkeeping and ledger but their definitions have changed slightly now you can think of a ledger as a database that you regularly record transactions in and the general ledger is a database that stores a complete record of all your accounts and journal entries time for those examples but first i quickly just like to say thanks to all of my youtube channel members you guys are absolute legends seriously i really appreciate your support it helps push me to keep on making more tutorials like this one if you haven't signed up yet and you'd like to become a member then just scroll on down below this video and click on the drain button simple as that thank you again appreciate it example one manual journal entries letter breeze general ledger looks something like this it's a collection of all your accounts and journal entries you have your assets your liabilities your equity your revenue and your expense accounts and as usual debits are on the left and credits are on the right it's the end of june and you've got a transaction to record for the last month you've been using electricity to power your cheese making machines but the electricity company hasn't sent you a bill yet which is completely fine but remember that in accrual accounting we record our expenses as we incur them and you're pretty darn sure that you'll are about 400 for june so let's record this transaction using double entry accounting first things first we'll debit overhead expenses to record a 400 cost in your income statement and then we'll credit accrued expenses by 400 to recognize liability in your balance sheet we'll add a description and a date june 30th because that's the date that we're going to record the transaction in your general ledger this type of transaction is called an accrued expense because you've used the electricity in the past but you haven't received an invoice or made the payment yet if you'd like to learn more about that i've made a whole video covering accrued expenses which i'll link to down in the bottom but what we're looking at here is a journal entry and that means that this is a record of a financial transaction and this is a manual journal entry because we're posting it ourselves if we pop back to our diagram we can see that we're posting this transaction directly into a general ledger kind of like this we're skipping past all of the sub-ledgers because you don't have one for accrued expenses so let's post this shall we you already have an overhead expenses account with an eighteen thousand dollar debit balance on the left hand side this is your beginning balance which you've brought forward and you also have an accrued expenses account with a six thousand five hundred dollar credit balance on the right hand side these are called t accounts because they look like t's when we post this manual journal entry into your general ledger you debit the left hand side of your overhead expenses account by 400 and you credit the right hand side of accrued expenses by 400 so your ending balance in your overhead expenses account is now eighteen thousand four hundred dollars which will carry forward into the next month and your crude expenses have increased to six thousand nine hundred dollars this is what we mean by posting a journal and now we can see how it affects your general ledger as a whole your overhead expense and accrued expense accounts have been updated to reflect the transaction example 2 and this time we're going to use a subledger and an automatic journal entry an account with a subledger is often called a control account take accounts payable for example this is a control account held in your general ledger and right now it has a balance of three thousand dollars but what's that three thousand dollars made up of we can't really tell by looking at the general ledger it just doesn't give us enough detail if we want to know who your business owes money to then we need to look at the accounts payable subledger you can think of this as a mini database that supports the main accounts payable account in the general ledger these two things are separate but they interact with each other and the totals always have to match in the accounts payable subledger we can see that let it bree owes money to three different suppliers and if we look a little closer we can see exactly which invoices make up the balances pretty handy hey now let's take a closer look at dairy lane you've been buying milk from them for a while now and they're kind enough to let you pay on account which means that you don't have to pay for your milk right away each time you buy some you're handed an invoice and you're given 30 days in order to make the payment at the moment you owe dairy lane a total of 1 700 dollars which is split across three different invoices and today you decide to pay the oldest one invoice one four eight five which is for one thousand dollars this payment is going to hit two places your accounts payable sub ledger and your cash book in your accounts payable sub ledger the one thousand dollar payment is allocated against invoice 1485 so this balance is cleared down to zero and now you're left with two open invoices which add up to seven hundred dollars and your accounts payable sub ledger now totals to two thousand dollars but how does this affect your general ledger specifically your cash account and your accounts payable control account remember these have to match their sub ledgers well these days accounting software is pretty smart and often when you make payments like this it'll trigger an automatic journal entry in the background what would that look like in this case the journal would debit accounts payable by one thousand dollars to reduce your liabilities and credit cash by one thousand dollars to reduce your assets as well this automatic journal entry will debit the left hand side of your accounts payable account reducing the balance down to two thousand dollars and credit the right hand side of your cash account bringing the balance down to 149 000 if we look again at your general ledger we can see that it's been updated your accounts payable control account now has a balance of 2 dollars which matches the sub ledger great stuff automatic journal entries like this can really save you a lot of time think of all that extra cheese your grandparents could have made they didn't have to do this by hand step four of the accounting cycle brings us to the trial balance what is a trial balance a trial balance or tb when abbreviated is an accounting report showing the closing balances of all general ledger accounts at a point in time back in the days of accounting on paper it was used to check that the debit and credit column totals match each other however since the introduction of accounting software that check has become less and less important since it's now done automatically nowadays it is an internal document that is typically used by accountants to check for errors and assist in the producing of financial statements it is also used by auditors in deciding which accounts to review okay so now we know what a trial balance means but what does it look like it looks like this we have a complete listing of all general ledger accounts running down the page with two columns for the debit and credit totals in the title we need to mention the period end date since we're looking at a snapshot at a point in time the account names are grouped by their type typically we start off with assets liabilities equity and dividends since this is the typical layout of a balance sheet then we have all of the revenue and expense accounts which make up the income statement or profit and loss to reduce the size of a trial balance accounts with zero balances are normally left out completely the columns that the account balances go in usually line up with the normal balances of the account types which we can remember using dealer dividends expenses and assets are normally debit accounts so these go on the left whereas liabilities owner's equity and revenue are normally credit accounts which go on the right the totals of the debit and credit columns should always match each other if they don't then you'll need to check over your workings for errors we're double entry bookkeeping at all times so the total debits and credits are always equal however debit and credit totals being equal doesn't mean our trial balance is error-free we could have switched the debits and credits in a journal and got them the wrong way round or we could have posted the same journal twice or not even posted it at all we could have posted the journal to the wrong account entirely or we could have posted a balance journal to the correct accounts but the numbers were wrong because we messed up our workings so by no means does a balanced trial balance mean that it's correct but it's certainly a good start example time we're going to build a trial balance for our window cleaning business it's been up and running for one month now so we're going to need to include all of those transactions from the previous two videos if you missed either of them you might want to hit that pause button now and go check them out to help clarify things to create this trial balance we're going to use something called the working trial balance this has a very similar format to the one that i showed you before except this time we aren't going to split debits and credits into separate columns instead we're going to identify debits as positive numbers and credits as negative numbers to help us distinguish between them to start things off we need a listing of all of the accounts our window cleaning business has then we're going to add seven columns to the right hand side of it six for each of the journal entries and a seventh to calculate the total balances in each of the accounts below the list of accounts we are going to add one final row for the totals of the columns so that we can check each of the journals bounce as we enter them now it's time for us to enter these journals i'm going to move through this next section quite quickly so if any of these accounting entries are making sense then check out those previous videos and you'll be fine first the business owner invests 100 and in return the business issues 100 in stock we're going to debit cash by 100 and credit owners equity by hundred dollars then the business takes out a further two hundred dollar loan to fund its activities we need to debit cash again by two hundred dollars and credit loans payable by two hundred dollars as well third the business spends thirty dollars in cash on window cleaning equipment we credit cash by thirty dollars and we debit equipment by thirty dollars next it spends a further fifty dollars on cleaning supplies the payment is made on account so we debit supplies by fifty dollars and credit accounts payable by fifty dollars after that the business makes one hundred and fifty dollars cleaning windows using half of its supplies in the process we debit cash by 150 dollars and credit revenue by 150 dollars to recognize the revenue we also credit supplies by 25 and debit cost of sales by twenty five dollars as well to account for half of the supplies being used up finally in the journal entries video we spent twenty dollars at the laundry to clean our equipment so we debit laundry costs by twenty dollars and we credit cash by twenty dollars now that we have all of our september journals written out we can take the totals for each account you'll notice that the sum of these totals is zero that's a good sign because it shows that our trial balance is balanced now one last thing to finish this off let's reformat our working trial balance to show our debits and credits in separate columns and let's rename this to trial balance for the period ended 30th of september the total of our accounts with a debit balance is 500 and the total of our accounts with a credit balance is also 500 so here we have our final trial balance for the september accounting period let's recap what we just learned there the trial balance is an accounting report that shows the closing balances of all gl accounts at a point in time it is an internal report used by accountants to check for errors and help produce financial statements the totals of the debit and credit columns must always match each other exactly for it to balance however balanced columns doesn't mean that the trial balance is error-free it's time for step five of the accounting cycle this is where we post adjusting entries i'll explain how they work in general and then we'll jump into each type one by one what are adjusting entries if you haven't heard of adjusting entries before it's the name that we give to the journal entries that we post at the end of each accounting period in order to bring our books into alignment with the accrual basis of accounting sound complicated well it is kind of so i've decided to create a mini series devoted to unraveling the mystery of adjusting journal entries and this is video number one we'll start off by taking a look at the big picture of accounting and then we'll drill in to uncover the problems posed by the accrual basis and how adjusting journal entries can help us work around them i'll explain what the four types of adjusting entry are and how to identify them prepaid expenses deferred revenue accrued expenses and accrued revenue my plan is to follow this video up with four more where we'll discuss how to record adjusting entries and go through worked examples for each type so subscribe and hit the bell to be notified when those come out i'll take all of these videos and pop them into one playlist that you can find up here once it's done got it good let me know in the comments which kind of adjusting entry you're having the most problems with and don't forget to watch this one through to the end to find out how all of this works let's get cracking i said that adjusting entries of the journal entries that we post at the end of each accounting period to bring our books into alignment with the accrual basis of accounting but what does that mean why would we do that i think we need to take a step back and look at the big picture of financial accounting financial accounting is the process of recording summarizing and analyzing an entity's financial transactions and reporting them in financial statements to its existing and potential investors lenders and creditors so ultimately as financial accountants our job is to produce financial statements to assist our key stakeholders with their decision making but what are financial statements you can think of them as formal reports that summarize a businesses financial performance position and cash flow collectively they give all of the interested parties an idea of the businesses financial health when preparing financial statements there are some rules that we need to follow the specifics differ slightly from country to country but broadly speaking we follow the generally accepted accounting principles gap for short or the international financial reporting standards ifrs now both gaap and ifrs have something in common they both require us to produce our financial statements in accordance with the accrual basis of accounting now the accrual basis of accounting is key to understanding adjusting entries so what is it in accrual accounting revenue is recognized as it's earned and expenses are recorded as they are incurred regardless of when cash or an invoice changes hands i made a whole video explaining what this means and its pros and cons versus the easier cash method of accounting that you can find linked up here and down below in the comments but the key takeaway here is that payments and invoices shouldn't dictate when we recognize our revenues or expenses instead we need to think about the substance behind each transaction that's the real trigger but the problem is that this doesn't just happen naturally and that's when adjusting entries come in let me explain a normal business transaction involves two parties a buyer and a seller the seller provides goods or services to the buyer and sends them an invoice and in return the buyer repays them in cash so there are three parts to this transaction we have the transfer of goods or services the invoice and the payment keep that in mind for a moment alongside all of this the financial statements we produce are designed to cover a range of time which we call an accounting period depending on the businesses reporting requirements this could be anything from a month to a quarter or even a full year if all three parts of this transaction happen in one accounting period then we're all good no adjusting entries are necessary but when they fall into different accounting periods then we've got a problem this is where adjusting entries come in there are two main types prepayments and accruals prepayments occur when goods or services have been paid for in advance whereas accruals happen when goods or services are to be invoiced in the future in a prepayment goods or services have been paid for in advance i'll show you how this works i think it's best if we think of this in terms of two accounting periods the past and the future with us being bang in the middle balancing on a tightrope in the present in a prepayment goods or services have been paid for in advance so that means that the payment happens back in the past for goods or services that are going to be delivered or consumed in the future the problem here is that normally the invoice and payment part of the transaction naturally triggers an accounting entry that recognizes the whole transaction in the past so if we were the buyer then we would have recognized an expense in the past and if we were the seller then we would have recognized the revenue in the past but we are accrual accounting so revenue should be recorded as it's earned and expenses should be recorded as they are incurred the goods or services are going to be provided in the future so the revenues or expenses should also be recognized in the future not the past so right now before the period closes we've still got a bit more time to make changes in the past we need to post an adjusting entry to reverse out those revenues or expenses from the income statement and hold them in the balance sheet where they don't impact our past financial performance then in the future accounting period we'll post another adjusting entry to release these from the balance sheet to the income statement so we've correctly recorded our revenue as it was earned or our expenses as they were incurred that's how prepayments work in general but really there are two types depending on where we fit into the transaction we have prepaid expenses and prepaid revenue which is more commonly known as unearned or deferred revenue if we're the buyer in the transaction then we're dealing with prepaid expenses because we're the ones receiving or consuming the goods or services however if we're the seller then we're on the other side of the transaction and we're dealing with prepaid revenue because we're the ones providing the goods or services accruals occur when goods or services are to be invoiced in the future these are almost the opposite prepayments goods or services are delivered in a past accounting period whereas the invoice and eventual payment come later in the future again we have a problem the accrual basis of accounting is telling us that revenues or expenses should be recognized when they're earned or incurred in this case the substance of the transaction happened in the past because that's when the goods or services were delivered or consumed however the natural accounting trigger in this situation happens in the future when the invoice is raised by the seller and received by the buyer so as things currently stand the transaction is going to be recognized in the future income statement to correct this we need to post an adjusting entry into the past accounting period to accrue the revenues or expenses into the income statement and the other side of that journal will be to temporarily hold their call as an asset or a liability in the balance sheet in the future once the invoice has been raised by the seller and given to the buyer we'll need to reverse this accrual so that we aren't recognizing this transaction twice that will release the original adjusting entry from both the income statement and the balance sheet again there are two categories of accrual accrued expenses and accrued revenue if we're the buyer in the transaction then we're dealing with accrued expenses because we're the ones receiving or consuming the goods or services however if we're the seller then we're on the other side and we're dealing with accrued revenue instead because we're the ones making the money by providing those goods or services so adjusting entries are required to bring our books in line with the accrual basis of accounting which is required under both gaap and ifrs when producing financial statements adjusting entries are divided into two categories prepayments occur when goods or services have been paid for in advance whereas accruals occur when goods or services are to be invoiced in the future if you're on the buying side of the transaction then you pre-pay or accrue expenses depending on the timing of the payment or invoice however if you're on the selling side then you defer revenue when you've been paid in advance and accrue revenue when you've already provided goods or services and plan to invoice the customer in the future what are prepaid expenses a prepaid expense is a future expense which has been paid for in advance now what does that mean it means that we made the payment in a past accounting period but we don't actually receive the underlying goods or services until a future accounting period right time for an example but first i want you to meet someone [Music] this is betty my humble toyota yaris she's not the biggest and she's certainly not the fastest in fact she's kind of old but she moves me around from a to b and for that privilege i have to buy car insurance unfortunately i live in vancouver which has some of the highest auto insurance premiums in canada paul betty who i bought for three thousand dollars cost me a whopping 2 400 to ensure for 2019 i paid for this in advance on december 15 2018 and i initially coded the whole payment to insurance expenses question what monthly adjusting entries do we need to post to record this transaction in line with the accrual basis of accounting we'll begin by taking stock of the facts at the end of 2018 we'd already paid for our insurance coverage for the following year so this was a future expense which i had paid for in advance does that sound familiar yes we are dealing with a prepaid expense i paid 2 400 in advance on december 15 2018 which i coded to the insurance expense account now what would that journal entry look like well i paid out two thousand four hundred dollars so my cash balance has to decrease by two thousand four hundred cash is an asset which is the a in dealer that makes it a normal debit account so debits increase it and credits decrease it that means that on december 15th i would have credited my cash account by two thousand four hundred dollars i already said that the other side of the journal went to the insurance expense account well expenses of the ian dealer also a normal debit account so to increase them i would have debited the insurance expense account by two thousand four hundred dollars here we have the initial journal entry when i posted it it would have hit both the cash account in the balance sheet and the insurance expense account in the income statement we can visualize the impact of this journal entry on the general ledger using t accounts in t accounts debits always go on the left and credits always go on the right so this is the result of that initial entry back in december 2018 and it would have been fine if we were cash accounting because when we cash account we record expenses once cash is paid out but the problem is we're accrual accounting so expenses should always be recorded as they are incurred and that means that our expenses at the end of 2018 are overstated by 2 400 time for our first adjusting entry i'm going to show you how to record a prepaid expense we're going to need to post this one into the december 2018 accounting period before it gets closed for good our insurance expense account is overstated by 2 400 so our adjusting journal needs to clear all of this out last time we debited the account so this time we need to credit the insurance expense account by two thousand four hundred dollars but where does the other side of this journal entry go we can't put this anywhere in the income statement because that will affect our profit for the year that leaves us with one option the balance sheet but where in the balance sheet is a prepaid expense an asset or a liability well there's an easy way to check this assets bring us future economic benefit whereas liabilities involve a future economic sacrifice in this situation i've already paid for the car insurance so now it's down to the insurance company to provide me with coverage for the next 12 months i'm going to receive the benefit of that coverage so this prepaid expense should be recognized as an asset in the balance sheet in fact prepaid expenses are always recognized as assets in the balance sheet that means the other side of the journal entry is a debit of 2400 to prepaid expenses in the balance sheet let's update our t accounts to find out what impact this journal entry had on the general ledger so at the end of 2018 we have negative cash of two thousand four hundred dollars no insurance expense in an income statement and a two thousand four hundred dollar prepaid expense which we're holding as an asset in the balance sheet this is exactly where we want to be now when it comes to 2019 we have some more adjusting entries to post 12 in total one for each month of the year so let's bring up a timeline for 2019 and break it down into 12 accounting periods from january 1st all the way through to december 31st in accrual accounting expenses are recorded as they are incurred so we need to release our prepaid expense from the balance sheet as we consume or get the benefit from our insurance policy in january 2019 i've consumed 1 12 of the insurance coverage 1 12 of 2 400 is 200 so the insurance expense that we need to recognize in our income statement is 200 for january 2019. the adjusting journal entry that we need to post looks like this we need to debit the insurance expense account by 200 to increase our expenses in the income statement and we need to credit prepaid expenses by 200 to decrease our assets in the balance sheet so with 11 months of insurance coverage left on the policy we're carrying 2 200 of prepaid expenses as an asset in the balance sheet and we've incurred an insurance expense of 200 in the income statement this process of releasing prepayments from the balance sheet needs to continue for the rest of the year at the end of may we have consumed 5 12 of our insurance coverage so we need to have posted this journal entry five times recognizing a two hundred dollar insurance expense in the income statement on each occasion with seven months of insurance coverage left on our policy we have one thousand four hundred dollars of prepaid expenses held in the balance sheet and one thousand dollars of insurance costs expensed in our income statement five months of policy consumed over a 12-month period which gives us one thousand dollars likewise you could do the same to work out the prepaid expense in the balance sheet we have seven months of coverage or future economic benefit left on the policy so we have prepaid expenses of two thousand four hundred dollars multiplied by seven over twelve which gives us an asset of one thousand four hundred dollars in the balance sheet come december 31st the adjusting entry we need to post is exactly the same as the ones that we posted for the previous 11 months debit insurance expenses by two hundred dollars in the income statement and credit prepaid expenses by two hundred dollars in the balance sheet however this time we've consumed all of our insurance policy we are no longer expecting to get any future economic benefit so we are no longer holding any prepaid expenses in the balance sheet this asset has been reduced to zero because we have released all of it to the income statement where we have recorded an insurance expense of two thousand four hundred dollars for 2019. our cash account is still showing a credit for december in the prior year because that's when we paid for the policy so we've recorded our expenses as we incurred them and our books are in line with the accrual basis of accounting what is deferred revenue deferred revenue is what we call the payments that a business receives in advance for goods or services that haven't yet been delivered or provided you might have heard of prepaid revenue or even unearned revenue well all of these are actually the same thing they're just different ways of saying deferred revenue um okay that's a bit old three different terms that all mean the same thing let's try clear things up with a couple of examples in this first one i want you to imagine that you're the owner of a seaplane random i know but bear with me i live in vancouver and for a while now i've been wanting to visit vancouver island if i were to take the ferry out there this whole trip would take me three to four hours but lucky for me you own a seaplane so i head downtown to the seaplane terminal and boom there's a spot on your seaplane and it's leaving in 20 minutes the ticket cost me 200 so i pay you the money and half an hour later we're checking out the beautiful gardens on the island in this transaction you're the seller and i'm the buyer you provided me with a service by flying me out from vancouver all the way over to the island the question is how should you account for this transaction well as the owner of the seaplane you've received two hundred dollars in cash cash is a type of asset the a in dealer so debits increase it and credits decrease it your cash balance has gone up so you need to debit your cash account by 200 to increase your cash the other side of this transaction is going to affect revenue in your income statement revenue is the rn dealer a normal credit account so credits increase it and debits decrease it your revenue has gone up so you credit your revenue account by 200 to increase your income this is what your journal entry looks like and we can see how this journal entry affects your general ledger using t accounts i'm sorry i've got a sore throat today this journal entry affects two accounts cash and revenue remember when using t accounts debits always go on the left and credits always go on the right so we debit your cash t account by two hundred dollars to increase cash in your balance sheet and recredit the revenue t account by 200 to increase revenue in your income statement nice one that's the first example finished it wasn't so bad was it you're probably thinking well yes because there weren't any adjusting entries in this one you are spot on this transaction didn't include any deferred revenue or adjusting entries of any kind because both the payment and services happened on the same day in the same accounting period for deferred revenue to get involved in all of this we would need a special set of circumstances i would need to pay to you in advance in a past accounting period and you would need to be providing me with the service in the future accounting period i'll show you how this works in this second example this time no more seaplanes i want you to picture yourself as a commercial pilot on a passenger jet it's june and i'm getting homesick i want to buy a return flight from vancouver to the uk to see all of my friends and family it's been ages since my last visit so this time i decide to go there for a whole month i buy a return flight for 800 in june on your airline my outbound flight is going to be the next month in july and the return leg is going to happen the following month in august this is our timeline we have three accounting periods june july and august to account for this transaction you're going to need to post three adjusting entries one in each month so let's do the first one in june i paid for my tickets but from your point of view at the airline you received eight hundred dollars in cash you need to post a journal to debit your cash account by eight hundred dollars to increase your cash right up to this point this journal is looking very familiar it's basically the same as the one from the first example you just need to post another 800 credit to revenue and we've got this is embarrassing let me think you're a commercial pilot of an international airline large businesses like that use the accrual basis of accounting but if we were to recognize this income right now then we would be cash accounting because in cash accounting you record revenue as you receive the cash whoops so i wasn't meant to credit revenue this time round because we are a cruel accounting okay i think i've got this now this time we don't credit revenue in the income statement because we are a cruel accounting in accrual accounting revenue is recognized as is earned not when cash changes hands you haven't provided me with a service yet so you can't recognize any of this revenue so this entry can't go anywhere that affects the income statement so that leaves us with one option the balance sheet but is deferred revenue and asset or reliability let's work it out assets bring us future economic benefit whereas liabilities involve a future economic sacrifice in this situation i've already paid for a plane ticket so now it's down to you to fly me out to the uk and back you've got work to do so you are going to make a future economic sacrifice so you need to recognize this deferred revenue as a liability in the balance sheet in fact deferred revenue is always recognized as a liability in the balance sheet so the other side of this journal entry is going to need to increase our deferred revenue in the balance sheet deferred revenue is a liability the l in dealer so it's a normal credit account credits increase it and debits decrease it so you need to credit your deferred revenue in the balance sheet to increase it by 800 let's see how this journal affects your general ledger now you've got three t accounts cash and deferred revenue in the balance sheet and revenue normal revenue in the income statement your cash account has a debit balance of 800 from my initial payment and your unearned or prepaid revenue account holds a liability of 800 the normal revenue account is empty because we can't recognize any revenue at this point let's fast forward to the end of july you've flown me out to london so half of my return trip is complete if revenue is recorded as it's earned then you've earned half of your income the problem is as things currently stand you're holding 800 as a liability in the balance sheet this deferred revenue is not the same thing as normal revenue that flows through your income statement you're going to need to post an adjusting entry to fix this situation let's do it we'll start off by debiting deferred revenue by 400 because we want to reduce this liability in the balance sheet and release half of it to the income statement but where does the other side of this adjusting journal entry go we need to credit to the revenue account by 400 to increase our revenue in the income statement let's jot down how this adjusting entry is going to affect your t accounts we need to debit the left hand side of the deferred revenue t account by 400 and credit the right hand side of the revenue t account by 400 so as things currently stand you have cash of eight hundred dollars from that initial payment and you are holding deferred revenue of four hundred dollars as a liability in your balance sheet we've released the other four hundred dollars which we now recognize as revenue in the income statement in august you fly me back to vancouver so the second leg of our round trip is complete you have one more adjusting entry to post this adjusting entry is going to be exactly the same as the one that we posted previously we need to debit deferred revenue by four hundred dollars to decrease it in the balance sheet and credit the normal revenue account by four hundred dollars to increase that in the income statement you post this adjusting journal entry and it hits your general ledger so in your august balance sheet you are still carrying that 800 of cash from the initial transaction but you no longer have any deferred revenue why because it has all been released to the income statement four hundred dollars in july when you performed half of the services and the other four hundred dollars in august where you completed the round trip you have successfully recorded your revenues as they were earned so your books are in line with the accrual basis of accounting what are accrued expenses an accrued expense is a past expense that hasn't been recorded or paid for yet let's pause for a moment and think about what this means an accrued expense is a past expense that hasn't been recorded or paid for yet so this expense will be recorded or paid out in the future but right now in the present we're still waiting for that to happen got it this will all become clearer with the example that we'll get into shortly but first let's think about how a typical business transaction works imagine that we're the buyer and we want to buy something from someone the seller they send us the goods or provide us with a service and in addition to that they hand us an invoice in return we pay them in cash voila transaction complete with accrued expenses the seller provides us with the goods or services sometime in the past but we don't receive the invoice from them or make the payment to them until later in the future why why why does all of this matter because as financial accountants we like to use the accrual basis of accounting and in accrual accounting expenses are recorded as they are incurred not when cash changes hands i like to think of payments as accounting triggers when we pay money out of our bank account to a supplier we code the payment to the relevant account in the general ledger receiving an invoice is also an accounting trigger when using accounting software like quickbooks online you are required to enter the details from the invoice into your account's payable ledger once you've received it i'll explain how this works later in the example okay why does all of this matter my point is that we have two accounting triggers the invoice and the payment if both of these are going to happen later in the future then right now in the present we've got a problem we have no accounting triggers to record the goods or services when we receive them in the past that's when the substance of the transaction took place that's when the expense was incurred and accrual accounting is telling us that we need to record the transaction here but how do we go about accruing an expense in the past i'll show you right now let's imagine that we own a business and there are some basic overhead costs associated with running our office things like electricity heating and water we call these utility expenses and for now let's focus on water in our office we are built for our water usage on a quarterly basis four times a year and on each occasion the bill covers our water consumption for the previous three months today is november first the first day of a new billing cycle that means that three months from now on the 31st of january we'll receive a water bill covering three months november december and january three accounting periods and to keep things simple let's assume that water normally costs us about fifty dollars per month let's jump forward now to november 30th one month has passed and it's the end of an accounting period do we have any adjusting entries to post yes we do we've been using water for a whole month but we haven't received a bill or paid for any of that consumption yet so we need to accrue an expense into our general ledger and how do we do that we post a journal entry we need to recognize a utilities expense in our income statement water normally costs us 50 dollars per month so we need to increase our utility expenses by 50 expenses are the first e in dealer normal debit accounts so debits increase them and credits decrease them our utility expenses need to go up so we debit our utilities expense account by 50 but where does the other side of this transaction go we are double entry accounting so there is another side to this adjusting journal entry we've already hit expenses in our income statement so we need to temporarily hold the other side of this journal entry somewhere in our balance sheet in our accrued expenses account but are accrued expenses and asset or reliability let's work it out assets bring us future economic benefit whereas liabilities involve a future economic sacrifice we've already received economic benefit from this transaction because we've been using water for the past month but we haven't paid for it yet at the present moment we are committed to making a future economic sacrifice so we have to recognize an accrued expense as a liability in the balance sheet accrued expenses are always recorded as liabilities in the balance sheet and liabilities are the l in dealer normal credit accounts so credits increase accrued expenses and debits decrease them so we need to credit our accrued expenses to increase them by 50 in the balance sheet great let's see how this adjusting journal entry affects our general ledger using t accounts we have two t accounts the utilities expense account in the income statement and accrued expenses in the balance sheet remember when using t accounts debits always go on the left and credits always go on the right we debit the left-hand side of the utilities expense account by fifty dollars and we credit the right-hand side of accrued expenses in the balance sheet by fifty dollars so we have accrued a utilities expense of fifty dollars in our income statement for november now let's jump forward to the end of december another month has flown by do we have any more adjusting entries to post yes we do we've consumed another month's worth of water and we still haven't received a bill or pay for any of it yet we need to accrue some more utility expenses the journal entry looks like this it's exactly the same as the one we posted last month why because we estimated that water costs us roughly fifty dollars per month so we need to recognize another fifty dollars of utility expenses in december and on the flip side we need to increase our accrued expenses in the balance sheet by another fifty dollars and how does this impact our books like this our utility expenses now come to one hundred dollars fifty of which was expensed in november and another 50 in december in our balance sheet we are now carrying accrued expenses of 100 this liability keeps getting bigger because we've now gone two months without an accounting trigger to settle this once and for all we haven't received a bill or a payment in november or december so we are making our best estimate of what the bill might be at this stage okay now we'll jump forward to the end of january the final month of our quarterly billing cycle the water company has sent us an invoice covering the past three months and it comes to 153 so it's not bang on the 150 dollars that we expected but that's okay we used our best estimate and we actually came in pretty close like i mentioned before i like to think of invoices as accounting triggers here's what i meant by that when we enter this invoice into quickbooks online or whatever accounting software you're using we need to categorize the transaction and when we do this it automatically triggers a journal entry that gets posted behind the scenes in our general ledger if you run a business and receive lots of invoices then this automatic posting can become a huge time saver and it's one of the many benefits of using accounting software i'll pop a link down in the description to a free trial of quickbooks online so you can test it for yourself it's an affiliate link so by signing up you'll have the opportunity to support me making more accounting tutorials just like this one the automatic journal entry looks like this it debits our utilities expense account by 153 dollars to increase our expenses the other side of this journal entry is going to credit our accounts payable account by 153 dollars in the balance sheet i just want to point out at this moment that we haven't actually paid our water bill yet we have only received the bill and now we have 30 days in order to make the payment we owe money to the water supplier so we have a liability in our balance sheet how does this affect our general ledger we need to credit our new t account accounts payable on the balance sheet by 153 that's the final balance of what we owe to the supplier and we debit the utilities expense account in the income statement by 153 but hang on our utility expenses are now 253 dollars that's quite high our final bill was only 153 dollars how does any of this make sense we accrued 50 of utility expenses in november and another 50 in december when we add the 153 dollars that was automatically journaled in january we get 253 both our expenses in the income statement and our liabilities in the balance sheet are overstated by 100 that's because we have one more adjusting journal entry to post we need to release our accrued expenses from the balance sheet so let's do that the journal entry looks like this we need to reduce our accrued expenses in the balance sheet accrued expenses are liabilities so we reduce them by debiting the account by 100 our utilities expense account and income statement is also overstated this is a normal debit account so to decrease it we credit the utilities expense account by 100 we post this journal entry into the january accounting period debiting the left-hand side of accrued expenses in the balance sheet by 100 and crediting the right-hand side of the utilities expense account in the income statement by 100 when we close off the quarter we have incurred utility expenses of one hundred and fifty three dollars in our income statement fifty dollars which we accrued in november another fifty in december and then in january we took up a further fifty three dollars there are no more accrued expenses in our balance sheet because we released our 100 accrual in january and we now owe 153 dollars to our water supplier which we recognize as a liability in accounts payable we've recorded all of our expenses in the correct periods as we incurred them so our books are in line with the accrual basis of accounting what is accrued revenue accrued revenue is revenue that has been earned but not invoiced yet sometimes you'll hear it called unbilled revenue but accrued revenue is what it's more commonly known as that was the definition but what does it really mean accrued revenue is revenue that we've earned in the past that we haven't built the client for yet so as of now in the present we haven't raised an invoice yet that'll happen later in the future i think it's easiest if we think of this in terms of a buyer and a seller if we're the seller then we provide goods or services to the buyer once we've done that once the work is done we send them an invoice and in return they send us the cash transaction complete we accrue revenue whenever we have provided goods or services in the past that we haven't built the client for yet at some point in the future we intend to raise an invoice and after we've done that we'll receive the payment you might be wondering why do we do this why do we even bother it all comes down to the accrual basis of accounting because in accrual accounting revenue is recognized when it's earned not when cash changes hands the issue with this scenario is that we provided the goods or services in the past that's when we did the work that's when we earned the revenue but we haven't raised the invoice yet and invoices prompt us to record transactions in our general ledger so under normal circumstances we wouldn't be recognizing this revenue until the invoice is raised which in this situation will be sometime later in the future so right now in the present we need to post an adjusting entry into our general ledger to recognize the revenue in the past when we earned it sound confusing it's all good things will become a lot clearer with this example i want you to imagine that you're a web developer and i'm a small business owner who's desperately in need of a website i've checked out some of your work and i have to say i'm impressed so i hire you to design my website for 500 it's june 1st and you immediately get started come the end of the month you've finished up your work and the website's live i'm happy with the finished product and i'm ready to pay but the thing is you're busy with another job so you don't get around to raising the invoice until mid july let's work through the adjusting entries in this problem from your point of view on june 1st do you have any adjusting entries to post no you haven't done any work yet so you haven't earned any revenue what about june 30th yes now you need to post an adjusting entry over the previous 30 days you the seller provided me with a service by designing my website you earned this revenue but you haven't raised the invoice yet so you need to accrue this revenue into your books how do you do that by posting a journal entry you need to recognize revenue in your income statement revenue is the r in dealer a normal credit account so credits increase revenue and debits decrease revenue your revenue needs to go up so you credit your revenue account in your income statement by 500 dollars but where does the other side of this transaction go we're double entry accounting so there's another side to this adjusting journal entry you've already recorded revenue in your income statement so we need to temporarily hold the other side of this transaction somewhere in your balance sheet in your accrued revenue account but is accrued revenue and asset or liability let's find out shall we assets bring us future economic benefit whereas liabilities involve a future economic sacrifice you've already made an economic sacrifice by providing me with a service in june but you haven't been paid for this service yet you're going to see that economic benefit later in the future so you need to recognize accrued revenue as an asset in the balance sheet accrued revenue is always recorded as an asset in the balance sheet and assets are the a and dealer normal debit accounts so debits increase accrued revenue and credits decrease accrued revenue so you need to debit your accrued revenue account to increase it by 500 in the balance sheet nice one let's see how this adjusting entry affects your general ledger using t accounts you have two t accounts a normal revenue account in your income statement and an accrued revenue account in your balance sheet remember when using t accounts debits always go on the left and credits always go on the right you guessed it so you credit the right hand side of your normal revenue account by 500 in your income statement and you debit the left hand side of accrued revenue in your balance sheet by five hundred dollars this adjusting entry has allowed you to recognize 500 of revenue in your income statement in june when you earned it okay let's fast forward to july what happens when you raise the invoice you need to post another journal entry in this transaction you're the seller so you have raised a sales invoice sales invoices are recorded in accounts receivable accounts receivable is a subledger that tracks all of the amounts owed to you by your customers it's a type of asset the a in dealer a normal debit account so to record your sales invoice you need to debit accounts receivable by 500 to increase it in your balance sheet what's the other side of this journal entry you've debited something so now you need to credit something else to keep your books in balance last month you took up five hundred dollars of accrued revenue in your balance sheet and now you're about to take up five hundred dollars more of accounts receivable you don't want to overstay your assets so we can release that accrued revenue from your balance sheet now accrued revenue is a normal debit account so you decrease it by crediting 500 from the account how does this journal entry affect your general ledger well now you've got three t accounts normal revenue in the income statement accrued revenue in the balance sheet and accounts receivable which is also a balance sheet account when you raise the invoice in july you debited accounts receivable by five hundred dollars and credited accrued revenue by five hundred dollars you'll notice that your income statement hasn't been touched you have still recognized five hundred dollars of revenue in june when you earned it but you no longer have any accrued revenue in your balance sheet why because you raised a sales invoice so this asset these amounts owed to you have been transferred to accounts receivable in the balance sheet when i make the payment a few days later you'll receive cash for your services you'll need to debit your cash account by 500 because cash is an asset and credit accounts receivable by 500 to close the invoice this 500 asset which you initially held as accrued revenue has jumped from account to account in your balance sheet to accounts receivable when you raise the invoice and then to cash once you received the payment for your services so that's prepaid expenses deferred revenue accrued expenses and accrued revenue but these aren't the only adjusting entries in accounting we also have depreciation what is depreciation [Music] imagine that you own a bakery one day your oven breaks so you rush out to buy a new one plug it in or hook it up whatever you do with ovens and then you're back at it mixing kneading folding proofing [Music] oh hey there i'm james and this is the counting stuff anyway as time passes your new oven slowly wears down just like your old one and eventually it'll gray too this is where depreciation comes in what is depreciation it's the process of reducing the book value of a tangible fixed asset due to use wear and tear the passing of time or obsolescence an asset is something that you own that's valuable and which will bring you economic benefit in the future something like your oven which you'll use to make money your oven is a fixed asset because you'll use it for a long time and it's a tangible asset because it physically exists you can touch it you can't touch intangible assets and they don't appreciate they amortize instead but that's for another day the book value of your oven is its carrying amount in your businesses accounts we'll get into this soon but first why do we depreciate in accrual accounting revenue is recognized as is earned and expenses are recorded as they are incurred with depreciation we're particularly interested in the second line expenses are recorded as they are incurred what does this mean for fixed assets like your oven let's say that your oven has a useful life of 10 years you buy it at the beginning of year 1 and it costs you eight thousand dollars so you physically hand over the cash then but when do you actually use your oven bit by bit over the next 10 years depreciation journals are adjusting entries that we post at the end of each accounting period to bring your books into alignment with the accrual basis of accounting we do this to make sure that all of your oven's use and wear and tear is properly recorded as it's incurred not here when you paid for it but spread out over the next 10 years how does depreciation work it begins with buying your oven if you were using the cash method of accounting you would expense the entire cost of your oven straight to your income statement as soon as you hand over the cash but when you're using the accrual method of accounting you'd capitalize it instead capitalization is the process of recording a cost as a fixed asset in the balance sheet as opposed to an expense in the income statement so you take up your asset cost of 8 000 and hold it in your balance sheet then over the next 10 years you gradually write it off releasing it as an expense to your income statement now there are a few ways to do this this graph shows the book value of your oven over time the simplest appreciation method of all is called straight line depreciation this is a fixed cost method where the depreciation expense is spread out evenly over your oven's useful life but we also have the double declining balance and some of the year's digits methods these are what we call accelerated variable cost depreciation methods where the expense is higher in early years and then we have the units of production method this is also a variable cost depreciation method but it's not accelerated instead the depreciation expense mirrors the actual physical use of your asset over the past few weeks i've made videos covering each of these which you can find in my depreciation playlist i'll link to it down below in the description along with my depreciation cheat sheet seamless plug but in this video let's assume that you're using the straight line method here's your completed depreciation schedule this table summarizes the depreciation expenses accumulated depreciation and book values of your oven over its useful life you can learn how to make one of these in my straight line depreciation video but i'd recommend sticking around because i'm going to show you how to record all of these transactions in your business's books how to record depreciation using journal entries a journal entry is a record of a financial transaction and to help us figure these out we'll use dealer if you've been watching accounting staff for a while now then you might be familiar with this but if you haven't then maybe click subscribe why not dealer is an accounting acronym that stands for dividends expenses assets liabilities equity and revenue dea represent normal debit accounts which means they increase when debited and decrease when credited l e r are normal credit accounts these do the opposite they increase when credited and decrease when debited so let's do this how to capitalize an asset purchase at the start of year one you bought your oven for eight thousand dollars but what's the journal entry this is journal number one and as usual it has four columns date the account affected debits and credits you're going to post this in year one to record your asset purchase but which accounts will be affected we know that cash needs to go down by eight thousand dollars cash is an asset the a in dealer so it's a normal debit count which means that debits increase it and credits decrease it so we'll credit your cash account by eight thousand dollars to decrease its value in your balance sheet we're double entry accounting so there are at least two sides to this transaction what's the other one it has to be a debit because total debits need to match total credits but we can't debit expenses in the income statement not yet anyway because we're using the accrual method so we need to capitalize the cost of your oven and hold it as a tangible fixed asset assets are normal debit accounts so we'll debit your baking equipment account by eight thousand dollars to increase assets in your balance sheet we can see the impact of this journal on your bakery's books using t accounts so far you have one for cash and one for baking equipment a t-account is a visual representation of an account where debits go on the left and credits go on the right in journal one you credit the hand side of your cash account by eight thousand dollars to decrease it and debit the left hand side of your banking equipment accounts by eight thousand dollars to increase it this is a balance sheet to balance sheet transaction how to record a depreciation expense using journal entries during year one you write off eight hundred dollars as a depreciation expense to your income statement what does this journal look like we know it's going to hit the depreciation expense account in your income statement expenses are the first e in dealer normal debit accounts which means the debits increase them so you debit your depreciation expense account by 800 to increase it in your income statement but where does the other side go we need to decrease assets in your balance sheet so you might think it logical to credit baking equipment and you're not wrong that would make sense but we don't do that instead we're going to credit an account called accumulated depreciation by 800 accumulated depreciation is the cumulative total of all depreciation expenses incurred this might take a little bit more effort but doing it this way helps to keep things organized and that's a good thing it'll make more sense with t accounts you'll need two new ones accumulated depreciation and depreciation expense in your second journal you debit depreciation expenses by eight hundred dollars to increase them in your income statement and you credit accumulated appreciation by eight hundred dollars to reduce the value of your oven in the balance sheet your baking equipment and accumulated depreciation accounts both sit in the asset section of your balance sheet baking equipment is a normal asset account whereas accumulated depreciation is what we call a contra asset account what's a contra asset it's a normal credit account which contrasts or runs against the flow of normal assets a contra asset if you want to know the book value of your oven then all you have to do is net these two accounts together eight thousand dollars minus eight hundred dollars which leaves you with seven thousand two hundred dollars in your balance sheet so in year one your cash went down by eight thousand dollars and baking equipment went up by eight thousand dollars but later on this is offset by an 800 increase in accumulated depreciation because you've written off 800 as a depreciation expense to your income statement we can see all of this here in your depreciation schedule at the end of year one you have eight hundred dollars in depreciation expenses eight hundred dollars in accumulated depreciation and a closing book value of seven thousand two hundred dollars are you still with me it gets better i promise we're using the straight line method which means your depreciation expense is exactly the same for the next nine years so the next nine journal entries are identical to the one we just posted each year you debit the depreciation expense account in your income statement by eight hundred dollars and credit accumulated depreciation in your balance sheet by eight hundred dollars and here's the impact on your books at the start of year one you buy an oven so your cash went down by eight thousand dollars and your baking equipment went up by eight thousand dollars this is a balance sheet to balance sheet transaction but during each of the next 10 years you post adjusting entries to record a depreciation expense in your income statement of eight hundred dollars and eight hundred dollars in accumulated depreciation a contra asset account which offsets the asset cost in your baking equipment account after 10 long years the entire cost of your oven has been written off to your income statement so if we net together your baking equipment and accumulated depreciation accounts we can see that the closing book value of your oven has decreased to zero which agrees with your completed depreciation schedule so what's next nothing well not exactly if you continue to use your oven then this will be fully depreciated but you'll still be carrying it in your books eight thousand dollars in your baking equipment account and eight thousand dollars in accumulated depreciation but it combined a net book value of zero when you stop using it you'll need to post one more journal entry assuming no gain or loss on disposal you'll debit accumulated depreciation by eight thousand dollars and credit baking equipment by eight thousand dollars this journal clears out all of the older entries in your baking equipment and accumulated depreciation accounts leaving you with a balance of zero in each account how does straight line depreciation work straight line depreciation is a fixed cost depreciation method where the expense is spread out evenly over an assets useful life what does that all mean let me show you imagine that you're a farmer i know a bit random but stay with me you own a whole bunch of tangible fixed assets these are the physical things that help you out on the farm they are tangible meaning that you can touch them and they're fixed so you intend to use them for more than one year as time passes these tangible fixed assets wear down and aren't worth as much as they were when you bought them take your combine harvester let's assume that this one cost you 450 000 you expect to get 12 years of use out of it and after that you'll probably sell up the scrap and get back around ninety thousand dollars let's depreciate it using the straight line method step one write down what you know you know that this asset is a combine harvester and that you're going to depreciate it using the straight line method the asset cost is what you initially paid for it 450 000 a lot of money you estimate that its residual value or salvage value is 90 000 and that it has a useful life of about 12 years step 2 build a depreciation schedule the depreciation schedule is a table and straight line depreciation it has five columns year opening book value depreciation expense accumulated depreciation and closing book value but what do all of these terms mean year is the accounting period opening book value is the carrying amount of your combine harvester at the start of the year this sits in your balance sheet depreciation expense is the value that you write off as an expense to your income statement during the year accumulated depreciation is the cumulative total of all depreciation expenses incurred and closing book value is the carrying amount of your combine harvester at the end of the year step 3 calculate the depreciation expense accumulated depreciation and book values for each period this is where things get real yes we need to fill in all of the blanks let's begin with your opening book value this one's easy it's your asset cost 450 000 now let's work out your depreciation expense i mentioned at the start that straight line depreciation is a fixed cost depreciation method where the expense is spread out evenly over the assets used for life so grab your calculator we're about to do some maths the depreciation expense can be calculated by taking your straight line depreciation rate and multiplying it by your depreciable cost your straight-line depreciation rate is one divided by the useful life of your combine harvester so that's one over twelve years which rounds to eight point three three percent depreciable cost is the difference between your asset cost and residual value four hundred and fifty thousand dollars minus ninety thousand dollars is three hundred and sixty thousand dollars this is the portion of the book value that we're depreciating eight point three three percent multiplied by three hundred and sixty thousand is thirty thousand dollars your combine harvesters depreciation expense in year one make sense if you need any help remembering the formula you can find it on my depreciation cheat sheet which you can buy on my website link in the description next we need to work out your accumulated depreciation which is the sum of all depreciation incurred to date in year one this is 30 000 exactly the same as your depreciation expense your closing book value is the carrying amount of your combine harvester in your balance sheet at the end of the year we can work it out by taking your opening book value and subtracting your depreciation expense four hundred and fifty thousand dollars minus thirty thousand dollars is 420 000 now with year one out of the way we just need to repeat the process over and over again for the next 11 years your closing book value in year one becomes your opening book value in year two your depreciation expense is fixed because we're using the straight line method so it's thirty thousand dollars accumulated depreciation is sixty thousand dollars and your closing book value is four hundred and twenty thousand minus thirty thousand which is three hundred and ninety thousand dollars the process doesn't change so here's the completed depreciation schedule you started off with a combine harvester costing 450 000 you then wrote off 30 000 as a depreciation expense to your income statement each year for the rest of your assets useful life you might notice that after 12 years the closing book value of your combine harvester is 90 000 and this matches the residual value that we chose earlier which is good because it means we haven't made any mistakes which is always a good sign let's take another look at that graph here we're tracking your combine harvester's book value over time your asset cost at the beginning is four hundred and fifty thousand dollars and its residual value at the end is ninety thousand dollars its depreciable cost is the difference between the two three hundred and sixty thousand dollars and it has a useful life of twelve years straight line depreciation is a fixed cost method which means the expense is spread out evenly over your assets useful life but there are other variable depreciation methods as well where the expense is higher in early years and these can be a bit more tricky i have videos covering the variable depreciation methods as well but in the interest of time let's keep things moving adjusting entries turn our unadjusted trial balance into an adjusted trial balance which is step 6 of the accounting cycle in step 7 we create financial statements the income statement the balance sheet and the cash flow statement let's spend a bit of time on each of these what is an income statement an income statement is the summary of a businesses revenues and expenses over a period of time in its basic form an income statement looks like this it's a summary of a businesses revenues and expenses over a period of time when we take our total revenue and subtract our expenses from it then we work out our profit or our loss we make a profit when our revenues exceed our expenses and on the flip side we make a loss when our expenses are more than the income we've earned this is why the income statement is also known as the profit and loss statement or the p l for short it lays out a road map for how we ended up here at the bottom line our profit or loss the income statement always covers a period of time which could be anything that we want it to be but typically we run it for a month a quarter or a full year if a balance sheet shows us a snapshot of a business's assets liabilities and equity at a single point in time then you can think of it as a photograph or a still frame taken from a video whereas the income statement covers a period of time it's like watching a clip of that video it has a beginning and it has an end and if we look at it carefully and analyze it then it can tell us a story but more on that later [Music] let's take a closer look at our income statement revenues less expenses make us a profit or a loss the problem with this layout is that it doesn't give us much detail it would be much better if we made things a little more descriptive for instance revenue there are many different types of revenue if we were running a business that sells physical products then we might want to call this product sales instead or if we provide services we could call this our services rendered this extra detail helps the readers of the income statement better understand what they're looking at clarity is the aim of the game here the same goes for expenses businesses typically incur many different types of expense but broadly speaking these can be broken down into two categories our direct costs of doing business and our indirect costs of running the business our direct costs of doing business are the costs which we can directly trace through to the products we've sold or the services that we've provided for a business that provides services we might call this our cost of services and if we sell physical goods then we could call this our cost of sales or our cost of goods sold direct costs like these are variable costs which increase in direct proportion to the sales that we've made if you're running a retail or wholesale business then these would include things like the original purchase price of the product that you're reselling or if you've run a manufacturing business then this would include the cost of your raw materials or the direct labor costs that went into producing your product as we make more sales we incur more of these direct costs cost of goods sold can be a bit of a tricky concept to understand at first it ties in very closely with inventory in the balance sheet if you'd like to see make a video explaining how all of that works then let me know down below in the comments and if you haven't already remember to hit that subscribe button so you don't miss out on all of the other accounting tutorials that we have coming out very soon back to the income statement when we take our revenue and deduct our direct costs of doing business we get to our gross profit if you're new to accounting then you'll soon discover that we have many different types of profit our gross profit is a really useful tool that allows us to measure the efficiency of our production and sales process i'll show you how that works in a minute but first let's jump back to indirect costs these are the costs of running a business which can't directly be traced back to the production of goods or the provision of services we sometimes call these overheads overheads can include fixed costs like rent employee salaries insurance costs admin expenses legal costs accounting costs marketing costs depreciation and amortization there's a lot of them fixed costs like these tend to remain the same they bear no correlation at all to the sales that your business has made however not all overheads are fixed variable overheads can loosely correlate with a businesses sales although they can't be directly traced back to the production of goods or the provision of services these include things like advertising costs which can indirectly drive sales and sales commissions utility costs could also be considered a variable overhead in a manufacturing business because these can increase as we ramp up production when we deduct our indirect costs of doing business from our gross profit we come to our operating profit operating profit measures the net income that we generated from operations this is the residual amount that's left over after deducting all of our direct and indirect costs of doing business so this is our basic income statement but how does it help us measure a business's financial health it does that by giving us a means to compare our financial performance against comparative accounting periods a comparative period is a different period of time it can be whatever we want it to be we could compare a current month income statement against last month's income statement or this year versus last year when we use comparative periods we can calculate the change or movement across each line item down the profit and loss statement and as accountants it's our job to support these movements with a narrative which explains all of the differences let's throw in some numbers into an imaginary company and i'll show you what i mean we'll compare the movements in our p l year on year this is going to be for a medium sized business so we can quote our numbers in thousands of dollars what have we got here our imaginary company has made sales of a hundred and ten thousand dollars which is up ten thousand dollars from what we made in the prior year our cost of goods sold have also increased by ten thousand dollars from thirty thousand dollars to forty thousand dollars that's left us with a gross profit of seventy thousand dollars which has remained unchanged our overheads are fixed at forty five thousand which gives us an operating profit of 25 000 in each period what can we learn from all of this well our sales have increased by 10 000 but our gross profit has remained exactly the same how can that be a useful metric that we can use to analyze this is gross profit margin we can calculate our gross profit margin by taking our total product sales and deducting our costs of goods sold and then dividing the whole lot by our product sales this measures how efficiently we've been producing and selling our imaginary product in this case our gross profit margin in the current year is around 64 which is actually down from last year's gross profit margin of 70 percent how's that possible well one of two things could be happening here our sales could be shrinking or our costs could be rising we could be selling more products but at a discount or the cost of our raw materials could be rising these are the questions that we need to be asking ourselves as accountants investors or small business owners we can compare metrics like the gross profit margin across comparative periods to help us identify what questions we should be asking and then that's when the work begins we need to find out the answers and use them to build a narrative that explains what's going on gross profit margin is just one of many business metrics that we can use to analyze the income statement if you'd like to see me make videos on the others let me know now this is still quite a basic income statement in reality there are other indirect costs of doing business which we might need to include as well things like interest expenses and tax these tend to slot in below operating profit because they aren't considered to fall within the normal cost of operations this is why operating profit is also known as ebit or earnings before interest and tax when we deduct our interest in tax from our operating profit we calculate our net profit the bottom line because it's at the bottom of the profit and loss statement so you can see that there are many different types of profit and loss to consider in accounting we start off with our revenue and we deduct our direct costs of doing business to come to our gross profit our top line profit below this we take out the indirect costs of running our business to find our operating profit our ebit our earnings before interest and tax and when we remove interest and tax we calculate our net profit the bottom line together these different types of profit help us measure performance over a period of time the main goal of most businesses is to maximize their profits so it's important to be clear on what that means and to be aware of the differences between gross profit operating profit and net profit which can each tell us a different part of the story how do you make an income statement financial statements are accounting reports that summarize a businesses activities over a period of time there are three main ones that you should know about they're called the income statement the balance sheet and the cash flow statement in this video i'll show you how to make an income statement we'll cover the other two next on this channel so if you'd like to watch those then consider subscribing the income statement is a financial report that summarizes a businesses revenues and expenses over a period of time it works like this if you take a business's revenue and subtract its expenses then you're left with a profit or a loss that's why it's sometimes called the profit and loss statement or the pnl but we'll call this one the basic income statement it's nice and simple but it doesn't give us much information we need to expand it out to see the full detailed income statement at the top we have operating revenue which is the income earned from doing business and then we take away any direct operating costs these are the cost of sales and that leaves us with a gross profit or a loss beneath that we subtract any indirect operating costs or overheads to reach an operating profit or loss and finally we take away the indirect non-operating costs things like interest expenses and tax which brings us down to the bottom line the businesses net profit or loss if you'd like to learn more about these terms then you can check out my other income statement video and i also summarize it all on my income statement cheat sheet and i'll leave links to both of those down in the description how do you make a basic income statement the first thing you'll need is a trial balance the trial balance is an accounting report showing the closing balances in all general ledger accounts at a point in time here's one for a dating app called tumble it's an adjusted trial balance which means that all of tumble's adjusting entries have already been posted and it was run on december 31st which happens to be the end of tumble's financial year this trial balance holds a complete list of tumbles accounts and closing balances debit balances go in the left column and credit balances go in the right column but how does this help us make an income statement well we can start by drawing a line because accounts in a trial balance are usually arranged in order above this line we have tumble's assets liabilities and equity these are all balance sheet accounts which we can ignore we're interested in this stuff below the line tumble's revenue and expenses which are their income statement accounts the basic income statement is tumble's revenue minus its expenses in this case they earned 60 million dollars in revenue and incurred 50 million 350 thousand dollars in expenses that leaves them with nine million six hundred and fifty thousand dollars in profit baby but how do we make the detailed income statement the method is pretty much the same if we go back to tumble's adjusted trial balance then all we need to do is categorize their expenses like we did before cost of sales is a direct operating cost general administrative selling marketing depreciation and amortization are all indirect operating costs and finally interest and tax expenses are indirect non-operating costs but please please be careful with depreciation and amortization if the long-term assets that they relate to aren't used in operations then these would also be indirect non-operating costs in this video i'm assuming that they are used in operations right that's the hard bit out the way all we need to do now is lift these numbers out of the adjusted trial balance and put them in the corresponding sections of the income statement that leaves us with a revenue of 60 million dollars just like before less 17 and a half million dollars in cost of sales which is a direct operating cost which gives us a gross profit of 42.5 million dollars then we deduct indirect operating costs to reach an operating profit of 10 million 450 000 and below that we subtract the indirect non-operating costs interest and tax which leaves tumble with a net profit of nine million six hundred and fifty thousand dollars on the bottom line what is a balance sheet a balance sheet looks like this the way it's presented can vary but there are some key elements at the core of the balance sheet that the rest of it's built around here we have a balance sheet for a business called craig's design and landscaping services that's because i took this one from the sample company in quickbooks online quickbooks online is the biggest cloud accounting platform in the world and they specialize in small to medium-sized businesses so i thought this one would make a good example if you're thinking this all looks a bit crazy then no worries i'm only showing you the finished product we'll piece together a simpler one of these for ourselves in a moment right i think it's time for a definition a balance sheet is a snapshot of a businesses assets liabilities and equity at a single point in time and that's exactly what we're looking at we have assets over here on the left and on the right hand side we have liabilities and equity beneath both of the headers we have all of the detail all of the individual groups of accounts summarized with their closing balances at the bottom of the balance sheet we have our total assets and total liabilities plus equity you'll notice that both of these numbers are exactly the same that's what we want to see it's the aim of the game here because the balance sheet as suggested by its name always has to balance so your total assets must be equal to your total liabilities plus equity if they don't match each other exactly then we've got a problem in the past people used to make their balance sheets manually and this was a pain in the you could easily waste hours or even days trying to figure out where the errors were in your workings but thankfully nowadays accounting platforms like quit books online exist they ensure that your balance sheet always stays balanced but anyway i promise you that we build ourselves a balance sheet from scratch and i meant it so here we are we have a clean slate we're going to build this balance sheet from the ground up using one key principle double entry accounting in double entry accounting every accounting entry has an opposite corresponding entry in a different account or put simply stuff the business owns is equal to the stuff the business owes we accountants call stuff that the business owns assets but the stuff that the business owes is a little bit more complicated we use two different words to describe it depending on who the business owes stuff to when a business owes stuff to third parties like lenders suppliers and employees we call them liabilities however when a business owes stuff to its owners we call it equity so we have assets are equal to liabilities plus equity this is the basic accounting equation and it always balances total assets must be equal to total liabilities plus equity now every financial transaction that a business is involved in affects this accounting equation so the values of our assets liabilities and equity are constantly changing but it's possible for us to take a snapshot and freeze their values at a single point in time when we do that we're looking at a balance sheet the thing is though that these three buckets are far too broad there are many types of assets liabilities in equity and it would be helpful if we could distinguish between them time for us to hop into google sheets and flesh out this balance sheet assets are broken down broadly into two main categories current assets and non-current assets current assets are short-term assets that can be converted into cash within one year some of the most common types of current assets are cash accounts receivable supplies inventory and prepaid expenses on the other hand non-current assets are long-term assets that are used in operations to generate profit they can't easily be converted into cash so we expect to hold on to them for more than one year two common types of non-current asset are long-term investments and property plant and equipment it's a similar situation for liabilities we have current liabilities which are a businesses obligations that need to be settled within one year from now these include accounts payable salaries payable taxes payable and accrued expenses and we also have non-current liabilities obligations that aren't expected to be settled within one year stuff like long-term loans and that leaves us with equity the final piece of the puzzle this section works a bit differently to assets and liabilities we have two broad categories to consider owner's equity and retained earnings you can think of retained earnings as profits held for future use and this is key because it's the profit in retained earnings that forms the link between the balance sheet and the income statement keep that in mind i'll demonstrate how it works in this next example but before we get stuck in let's do some housekeeping and tidy up this balance sheet by adding some totals on the left we have total assets and on the right we have total liabilities and equity these have to match each other exactly because the balance sheet always has to balance to emphasize this i'm going to add a little balance checker that'll take the difference between these two cells this should always be equal to zero now that we've built a template for our balance sheet it's time for some numbers let's go back to the scenario of the window cleaning business that we covered in the videos on t accounts journal entries and the trial balance i'll drop links to all of these down in the description we're going to use these transactions again so that you can see how all of these concepts fit together in the interest of saving you time i'm going to move through these transactions fairly quickly so if you find yourself getting stuck and wanting some deeper explanations of the debits and credits then go back and watch those videos on t accounts and journal entries by the way on a side note the trial balance is not the same thing as the balance sheet if you'd like to see me make a video explaining the differences let me know in the comments there are six transactions that we're going to cover and we'll work through them one by one filling out our balance sheet templates as we go in transaction number one the owner of the window cleaning business makes capital contributions of one hundred dollars we're double entry bookkeeping so this transaction is going to affect two accounts cash and owner's equity the business's cash is going to be debited to increase it by 100 and owners equity will be credited to increase that by 100 as well are we in balance yes we are in transaction number two the business takes out a further two hundred dollar loan to fund its activities we need to debit cash again by two hundred dollars to increase it and credit long-term loans by two hundred dollars to increase them too transaction three the business spends thirty dollars in cash on window cleaning equipment we credit cash is made on account paying for something on account means that you're agreeing to pay the supplier at a later date so we debit our supplies by fifty dollars to increase them and this time we don't credit cash we credit accounts payable by fifty dollars to increase them instead just a couple more transactions left to go you've got this these ones are going to affect our retained earnings account remember that means our profit held for future use and it links the balance sheet and the income statement together i'll show you how this works now transaction five the window cleaning business makes a hundred and fifty dollars cleaning windows and uses up half of its cleaning supplies in the process this transaction is a bit more tricky than the ones we've covered up to this point because there are two parts to it each with their own double entries the first thing that we need to do is recognize revenue earned to do that we debit cash to increase it by 150 and we also credit revenue to increase that by 150 dollars but hold up where does revenue go i can't see it anywhere in our balance sheet we're going to need to jot down an income statement for our window cleaning business an income statement is a summary of our revenue earned and expenses incurred over a period of time so here we have revenue of a hundred and fifty dollars almost there next we need to record the second part of the transaction half of our cleaning suppliers were used up on this job so we can't recognize those as an asset anymore they now make up our cost of sales which is a kind of expense and belongs in our income statement as well in the fourth transaction we spend fifty dollars on cleaning supplies so if we've used up half of them that we need to credit supplies by 25 to decrease them and debit cost of sales in the income statement to increase our expenses by 25 but our balance sheet still isn't in balance how can that be we need to build a bridge between the profiting our income statement and the retained earnings or profits held future use in the equity section of our balance sheet so the 125 dollars of profit in our income statement now flows through the retained earnings and balances our balance sheet one important thing to note retained earnings and profit for the year don't normally match each other exactly like they do in this example that just happens to be the case because we don't have any retained earnings from previous years and none of the profits have been drawn out of the business that being said the simplicity of this example is a great way to demonstrate this link between the income statement and the balance sheet we'll see how that works one more time in transaction six where our window cleaning business incurs laundry costs of twenty dollars the payment is made in cash so we need to credit cash by twenty dollars to decrease it and debit laundry costs by twenty dollars to increase them in the income statement our profit of a hundred and five dollars rolls up into the retained earnings section of our balance sheet giving us total assets of 455 dollars and total liabilities plus equity of 455 dollars as well and our balance sheet checker is showing zero good stuff how do you make a balance sheet the balance sheet is one of the three main financial statements the other two called the income statement which we did in the last video and the cash flow statement which we'll cover next time a balance sheet or a statement of financial position is a financial report that gives us a snapshot of a businesses assets liabilities and equity at a single point in time now if you've watched my videos before then you've probably heard this one the stuff that a business owns is equal to the stuff that a business owes in other words a business owns assets and it owes liabilities to third parties the difference between the two is called equity which is what the business owes back to its owners and so we have the accounting equation assets are equal to liabilities plus equity when we take a snapshot of this accounting equation at a single point in time we're looking at a balance sheet we'll call this one the basic balance sheet and as its name suggests it's got to balance that means that total assets must always equal total liabilities and equity a detailed balance sheet will look something like this we expand out assets into current and non-current current assets are short-term assets things like receivables and prepaid expenses on the other hand non-current assets are long-term assets there are two main types the ones that you can touch and the ones that you can't touch we do the same thing with liabilities current liabilities are short-term liabilities payables accrued expenses and deferred revenue and non-current liabilities long-term liabilities stuff like long-term loans equity on the other hand is a different kettle of fish first we have capital contributions which is the money invested into the business by its owners for a company with shareholders we might call this common stock and then we have the businesses retained earnings which are its accumulated profits held for future use i do have a balance sheet cheat sheet which summarizes all of this the links in the description anyways how do you make a basic balance sheet first you need another accounting report called a trial balance this shows us the closing balances for every general ledger account at a point in time here's a trial balance for a dating app called tumble it was run at the end of tumble's financial year december 31st and it's an adjusted trial balance because all adjusting entries have already been posted we can see all of tumble's accounts and balances debits are on the left and credits are on the right at the bottom we can see that the debits total to 87 million seven hundred thousand dollars which matches the total credits exactly this means that tumble's trial balance is in balance which is very important because if the trial balance is in balance then the balance sheet also has to balance i don't think i've ever said bound so much in my life accounts in a trial balance are usually arranged in a pattern above this line we have the stuff that tumble owns its assets and below the line we have the stuff that tumble owes its liabilities and equity we also have its revenue and expense accounts which we used last time to make the income statement by the way if you're finding these videos useful and you'd like to support the channel then you can click on the join button below thanks to all my channel members who've done that already you guys are absolute legends and i really appreciate it thank you so how do we make a balance sheet there's two ways to do this the right way and the wrong way and i'll show you both we'll start with the wrong way because this is a really easy mistake to make and it goes something like this we take all of tumble's assets liabilities and the equity accounts and we pop them in their sections of the balance sheet in theory it's the right thing to do but check this out total assets add up to thirty six million three hundred and fifty thousand dollars and total liabilities plus equity add up to twenty five million six hundred and fifty thousand dollars that's a difference of ten million seven hundred thousand dollars so this balance sheet doesn't balance what went wrong we forgot to include tumble's revenue and expenses these are part of tumble's retained earnings it's profits held for future use which also sit in the equity section of its balance sheet when we include them total liabilities plus equity also add up to 36 350 000 so tumble's basic balance sheet is in balance remember the balance sheet is a snapshot of a businesses assets liabilities and equity at a single point in time on the left side we can see what the business owns and on the right side we can see what it owes to third parties and its owners how do we make a detailed balance sheet we follow the same process but first we need to divide tumble's assets and liabilities into current and non-current cash accounts receivable other receivables and prepaid expenses are all current assets property plant and equipment and intangibles and non-current assets accounts payable taxes payable accrued expenses and deferred revenue are all current liabilities and long-term loans is a non-current liability in the equity section common stock is a type of capital contribution and everything below that is retained earnings these are tunnels profits held for future use their opening retained earnings at the start of the year less dividends plus tumble's net profit in the current year and that's it we can pick up all these numbers and put them in our detailed balance sheet so we've got current assets 31 million 50 000 and 5.3 million in non-current assets current liabilities of 14.4 million dollars and non-current liabilities of 1.2 million dollars then we have 1 million and 50 000 in common stock which is a type of capital contribution and finally nineteen million seven hundred thousand dollars in retained earnings or profits health of each use total assets are equal to total liabilities plus equity so this balance sheet is in balance what's the difference between a trial balance and a balance sheet both of these reports have balance in their names which makes them easy to get mixed up more on that soon along with a knowledge bomb that i'd like to share with you but first i want to explain how the trial balance and the balance sheet are actually very different from one another but also very similar at the same time cryptic the trial balance is an internal accounting report showing the closing balances of all general ledger accounts at a single point in time it looks like this we have three columns accounts debits and credits the accounts column contains a complete list of all of the general ledger accounts in a business and to the right of it we have the total debits or total credits in each account the trial balance shows us the closing balances of all of these accounts at a single point in time so we need to make that clear in the title i'm going to use old faithful the window cleaning example that we've covered a few times before so we'll run through our trial balance to september 30th and here are our closing numbers at the bottom of the trial balance we normally take the totals for both the debit and credit columns this is a check to ensure that our books are in balance because in double entry accounting debits and credits must match each other exactly at all times back when accounting was done manually the trial balance was used to check that total debits were equal to total credits across all accounts accountants would literally spend hours or even days trying to work out where they messed up if these totals didn't match each other exactly thankfully nowadays this check is done for us automatically when we use accounting software but to us accountants the trial balance is still an internal document that we use to check for errors there are a whole bunch of ways that those areas can still sneak their way into here another way that we accountants use the trial balance is to help us put together financial statements you can think of financial statements as formal reports that we use to summarize a business's financial performance position and cash flow the three main types of financial statement are the income statement the balance sheet and the cash flow statement the balance sheet is a snapshot of a business's assets liabilities and equity at a single point in time while this definition might sound similar to the trial balance it's actually quite different a balance sheet looks like this we have all of our window cleaning businesses assets liabilities and equity laid out for us separately on one page at the bottom we have our total assets and our total liabilities plus equity after all we're double entry accounting so the balance sheet has to balance we accountants prepare financial statements like the balance sheet to give our businesses key stakeholders an idea of its financial health who are the stakeholders our existing and potential investors lenders and creditors external parties that want to know about our financial position on the other hand the trial balance is used internally by us accountants to check the integrity of our financial data we run the trial balance as often as we need to get the job done whereas typically we only put together a balance sheet when we need to at the end of each financial year that's when we have to report our results to the external parties that i mentioned a moment ago so we have two very different reports with two very different purposes but here's where things get interesting i mentioned earlier that we accountants use the trial balance to help us prepare financial statements and the balance sheet is a financial statement one of the most important ones so when it comes to reporting time we begin by running a trial balance this is our starting point the foundation that we use to build the balance sheet we can see that here in our window cleaning business cash supplies and equipment are all types of assets that we report in the asset section of our balance sheet accounts payable and long-term loans are both liabilities which we report in the liabilities section and owner's equity yes you guessed it is a type of equity which goes here in the equity section of the balance sheet finally revenue cost of sales and laundry costs are a bit more complicated not too complicated just a bit because they get reported in two different financial statements the income statement which we use to track our profit and then again in the balance sheet in the equity section because retained earnings make up our profits held for future use you might be wondering why these totals are different that's because we netted together some of our debits and credits in the income statement before we took the profit through to the balance sheet so the trial balance and the balance sheet are two different reports but they have a strong link that binds them together we use the trial balance to create the balance sheet now what is a cash flow statement dramatic music in three two one you might have heard the expression cash is king well in this video i'm going to explain why the cash flow statement is so important and how to prepare it using the direct method we're going to cover the direct method first because it's considered to be more valuable to investors or to anyone who reads the cash flow statement however many people opt for the indirect method instead if you stick around with me until the end i'll explain why right i think that's enough bathing let's get started first i want to make one thing very clear cash and profit are not the same thing profit is revenue less expenses it's the bottom line on an income statement and relates to a period of time whereas you can think of cash as a bank balance at a point in time cash and cash equivalents also include physical or petty cash amongst a few other things although most conventional companies use bank accounts just like you or i might have i also want to make the point that cash flows are different to cash cash flows relate to the amount of cash that has flowed in or out of a business over a period of time now that might sound a bit more like profit but it isn't when using the accruals basis of accounting we apply the revenue recognition and matching principles so that means that revenue is recognized as it's earned not when cash is received and expenses are recorded as they are incurred not when cash is paid out that means revenue doesn't equal cash in and expenses doesn't equal don't equal cash out the biggest reason that small businesses fail is because of poor cash flow management many of these businesses would have been profitable but without having that cash available they're unable to pay their staff their creditors or the interest on their bank loans and this throttles them that expression that i mentioned a moment ago cash is king is used to emphasize the importance of cash flow particularly in small businesses now i feel like i'm harping on about this so it's time to move on but i can't stress this point enough it is crucial to keep a track of your cash flows and we do that using the cash flow statement or statement of cash flows this is one of the three main financial statements along with the income statement and balance sheet we have all three of them here made up for a company called chudley cannons incorporated the first thing to note is that the cash flow statement covers a period of time and we put this in the header remember i said that cash flows relate to the amount of cash that explode in or out of a business over a period of time here we have the year ended the 31st of december but this could easily cover a quarter or a month i think it's easiest to interpret the cash flow statement by starting at the bottom and working our way back up at the bottom we have cash at the start and end of the year which we get from the balance sheet over here when we take the difference between these numbers we get the net increase or decrease in cash for the year in this case it's 35 000 this number is key to the statement of cash flows because what we're going to do above is explain how and why the cash balance changed over the course of the year we are going to summarize what cash was spent on and what the sources were and reconcile it all back to this number and we do this by breaking it all down into three sections the last section is cash flow from financing activities financing activities include changes to share capital borrowings from a bank or from third parties here we have long term borrowings which i assume were from gringos the wizarding bank when a company borrows money there's cash inflow so your cash balance increases that's the case here since you can see that we have a cash inflow of twenty thousand dollars because the number is positive but cash can also flow out of a business through financing activities when you pay back a loan or buy back share capital above financing activities we have cash flow from investing activities investing activities most commonly relate to the sale or purchase of non-current assets or investments in stocks and shares that sit outside of a business's core operations when a business invests in non-current assets cash flows out because we have to pay the suppliers cash for these assets and on the flip side when we sell these assets off cash flows back in here the chudley cannons have fifteen thousand dollars of cash inflow from the sale of ppe which is shorthand for plant property and equipment and seventy thousand dollars of cash outflow from the purchase of ppe they are a quidditch team so they might have received the fifteen thousand dollars by selling off their old broomsticks in order to buy some of those new nimbus 2001s which cost them seventy thousand dollars this is an investing activity not an operating activity because buying and selling broomsticks is not the chubby cannons core business the broomsticks are long-term investments which makes them non-current assets this is different to inventory which describes assets that are intended to be solved during the ordinary course of business which brings us on to the first section of the statement of cash flows cash flow from operating activities operating activities are the principal revenue generating activities of a business that sounds like a mouthful but it just means the cash that we receive or pay out during the course of our regular business cash comes in when our customers pay us based on our accounts receivable and cash flows back out when we pay our supplies based on our accounts payable now at the start of the video i mentioned the direct and indirect methods of preparing a cash flow statement and i haven't brought them up again until now because everything that we've covered so far is identical under each method operating activities is the only section that's different today i'm going to cover the direct method and soon i'll do another video on the indirect method you can subscribe to the channel so you don't miss out so the direct method under the direct method the cash flow from operating activities is laid out just like a cash basis income statement under the cash basis of accounting revenue is recognized when cash is received and expenses are recorded when cash is paid out when you work out your operating profit under this method it should match your cash flow from operating activities let's check back on the chubby cannons this cash flow statement has been prepared under the direct method so under operating activities we first have cash receipts from customers of two hundred and twenty eight thousand dollars the cannons are a sport team so i would assume that the majority of these earnings would come from ticket sales and the sale of merchandise this 228 k of cash in would match their revenue for the same period if they were cash accounting but we can see that their income statement and balance sheet have been prepared under the accrual basis we know this because their income statement shows depreciation which is a non-cash transaction so it wouldn't show up in an income statement prepared under the cash basis their balance sheet also contains inventory receivables and payables none of which would appear in a cash basis balance sheet so we've covered cash receipts but the next four lines under the cash flow from operating activities all relate to cash paid out cash paid out to suppliers employees interest paid and income taxes paid when you compare this to the income statement you can see that each line relates to one of the expense types cash paid to suppliers relates to cost of sales cash paid to employees relates to the salaries expense interest paid relates to the interest expense and income taxes paid relates to the income tax expense there is no depreciation in this cash flow statement because depreciation is a non-cash transaction so that's the three sections of the cash flow statement and when we subtotal these we get 70k of cash in from operating activities 55k of cash out through investing activities and finally 20k of cash in from financing activities if we add all these together we get a net increase in cash of 35 000 which reconciles back to the movement of the cash balance in the balance sheet a closing balance of 185k less the opening balance of 150k is also 35 000 that's the statement of cash flows prepared under the direct method it's a really handy report for investors to read over because you can easily identify where cash flowed in and where it flowed out we can see that 76k was given out to suppliers which was our biggest cash outflow it's intuitive so it's the preferred method of producing a cash flow statement however at the start i said that many people go for the indirect method instead now why is that the thing is the cash flow from operating activities can be tough to work out using the direct method particularly for large companies using the accruals basis of accounting it can be costly and time consuming to gather all the information you need to put it together the indirect method is an easier alternative which is why most corporations favor it even though it's harder for investors to understand both methods are allowed under gaap and ifrs and although the direct method is preferred most companies opt for the indirect method instead what is the direct method of preparing a cash flow statement previously i showed you a cash flow statement for the chudley cannons quidditch team along with its corresponding income statement and balance sheet but if you missed part one there's a link to that over here as well in this video we're going to rewind a bit and prepare that same cash flow statement using t accounts and both of these reports we're going to use the direct method as we work out each number as we piece it together we're going to start off with the easy ones and move on to the harder calculations as we progress so i recommend watching this video through until the end to get a clear picture of the whole process let's begin so here we have the cash flow statement for the cuddly cannons and the plan is we're going to recalculate all of these numbers directly from the income statement and balance sheet for the same period the 31st of december we will start at the top with cash flow from operating activities and work our way down through all three sections to cash flow from financing activities we are using the direct method today so cash flow from operating activities mirrors the layout of an income statement prepared under the cash basis so we have cash receipts from customers at the top which reflect our sales and below that we have cash paid to suppliers employees and the rest of the expense types operating activities are the principal revenue generating activities of a business so this section shows the cash that we receive or pay out during the course of our regular business the first line item that we're going to calculate is cash receipts from customers and to do this we're going to need to look at the movement in our accounts receivable balance i said in the intro that we'll need some t-accounts so let's draw those out accounts receivable is an asset which is the a in dealer so it's a normal debit account that means our opening balance or our balance brought forward goes on the left side of the t account because debits always go on the left the accounts receivable balance increases as we make revenue because when we credit sales we debit accounts receivable so sales go on the left side as well and finally the closing balance or the balance carried forward also goes on the left because it's a normal debit account opening and closing balances for normal debit and credit accounts should always be on the same side as each other on the credit side of the t account which is on the right we have cash receipts from customers cash received from customers reduces our accounts receivable and this is what we're looking to solve for because cash receipts from customers ties back to our cash flow statement now we've laid out our t account let's enter some numbers we get our opening balance from the balance sheet for the previous year in this case accounts receivable were 98 000 as at the 31st of december for the prior year so we can write this down in the t account sales come straight from the income statement this year the cannons made sales of 250 000 so we need to debit accounts receivable by 250 and finally our closing balance comes from the balance sheet this time from the current year accounts receivable at the end of the current year 120 000 so that goes on the left at the bottom of the t account now we only have one missing value cash receipts from customers and we can work this out using some basic maths our closing balance of 120 less our sales of 250 less our opening balance of 98 gives us minus 228. the negative sign signifies that this is a credit so we write this down on the credit side of our t account as you can see this ties back to the 228 that we have in our cash flow statement all as well next i'm going to skip over cash pay to suppliers and return back to it later in this video because it's actually one of the harder balances to calculate so instead we move on to cash paid to employees the balance sheet account that we're going to need for this one is salaries payable salaries payable is a form of liability the l in dealer so it's a normal credit account that means our opening balance goes on the right hand side of the t account because credits always go on the right the balance on this account increases as the salaries expense goes up because when we debit the salaries expense we credit salaries payable so these go on the right and lastly the closing balance joins the opening balance on the right hand side because we have a normal credit account we are looking to solve the cash paid employees which will show as a debit on the left-hand side of this t-account because when we pay out cash to employees we reduce salaries payable this is the only unknown value for us at this stage because we can easily pull the opening and closing balances from the prior and current year balance sheet and we can get the salaries expense from the current year income statement so let's do that the prior year balance sheet shows a closing balance in salaries payable of 30 the current year income statement shows the salaries expense of 80 and the current year balance sheet shows a closing balance in salaries payable of 42. let's write these down in the t account and work out cash paid to employees our closing balance of negative 42 less the salaries expense of 80 less the opening balance of 30 gives us cash paid to employees of 68. this number is positive so we debit the t account by 68 and does it tie back to our cash flow statement yes it does perfect next up we need to work out interest paid we're going to run through this one a bit quicker because the balance sheet account that we use to work this out is interest payable which is also a liability so the process is very similar to cash paid to employees that means that the opening balance the interest expense and the closing balance all go on the right hand side of the t account because interest payable is a normal credit account on the left side the debit side we are looking to solve for interest paid we should tie back to the cash flow statement we are again going to look for the opening and closing balances in the respective balance sheets and for the interest expense in the income statement so here we go the prior year balance sheet shows a closing balance in interest payable of two the current year balance sheet shows a closing balance in interest payable of three and the current year income statement shows an interest expense of eight so let's enter these into our t account to work out interest paid our closing balance of negative three less the interest expense of eight less the opening balance of two gives us interest paid of seven it's positive so we debit the t account by seven thousand when we check back against the cash flow statement we can also see interest paid of 7 000 so it matches the last line in cash flow from operating activities is income taxes paid which we will work out now the balance sheet account that we're going to need for this one is income tax payable and since that's also a liability the process is going to be very similar to the previous two examples the opening balance the income tax expense and the closing balance go on the right hand side of the t account because we are dealing with a normal credit account on the debit side we have income tax paid which we are solving for the opening and closing balances will again come from the balance sheets and we will get the income tax expense from the income statement the prior year balance sheet shows a closing balance in the income tax payable of four the current year balance sheet shows a closing balance of six and the income statement shows an income tax expense of nine we enter these into the t account to work out income tax paid our closing balance of negative six less the income tax expense of nine less the opening balance of four gives us income taxes paid of seven so we debit the t account by seven thousand and this ties back to income taxes paid in the cash flow statement how do you find that brace yourselves because we're about to take on something a bit more challenging we're going to head back to cash pay to suppliers which we left out earlier and i'll show you how to calculate it the balance sheet account that we need here is accounts payable which is a liability now you might be thinking but james we just did three liability t accounts isn't the process going to be exactly the same bear with me for a moment and i'll explain why it's different we lay out the accounts payable t account as we've done before the opening balance inventory purchased and closing balance go on the credit side and cash paid which we're solving for again goes on the debit side we can easily pull the opening and closing balances from the prior and current year balance sheet in this case we have an opening balance of 95 and a closing balance of 105 so all we need now is inventory purchased and we're on our way but how do we find inventory purchased there isn't an inventory expense in the income statement all we have is cost of goods sold bummer what we have to remember here is that we are counting using the accrual basis and under the accrual basis we apply the matching principle which states that revenue and all expenses incurred in order to generate that revenue need to be recognized in the same accounting period now what that means for us in the context of this example is that when we purchase goods from suppliers that we intend to sell we can't immediately recognize an inventory expense in the income statement that's because our intention is to sell our inventory in order to generate sales and if we're generating sales then the matching principle is telling us that we need to recognize those sales and their related expenses in the same accounting period in order to do that we need the help of another account inventory having an inventory account means that we can store the costs of all goods that are intended to be sold as a debit balance in the balance sheet and when they are sold we decrease inventory in the balance sheet an increased cost of goods sold in the income statement let me explain this using an inventory t account inventory is a form of asset which makes it a normal debit account so the opening balance inventory purchases and the closing balance go on the debit side on the credit side we have cost of goods sold we can easily find the opening and closing balances by referring to the prior and current year balance sheet here we have an opening balance of 68 and a closing balance of 94 which we will write down in our t account and we can find cost of goods sold in the income statement which in this case is 60 so we write 60 on the credit side of the t account because when we sell inventory we debit the income statement to recognize the expense and we credit inventory in the balance sheet to reduce our assets that leaves us with inventory purchases which we can work out using the other numbers a closing balance of 94 less the opening balance of 68 and adding back cost of goods sold of 60 gives us inventory purchases of 86 so we debit the t account by 86 you might have noticed already that it was inventory purchases that we were looking for in our accounts payable t account so we can copy the 86 over to the credit side of accounts payable because when we purchase inventory we debit inventory to increase it and credit accounts payable to increase the amount that we owe to suppliers now that we've worked out that number we're on the home straight to calculating cash paid to suppliers our closing balance of negative 105 less inventory purchases of 86 less our opening balance of 95 gives us cash paid to suppliers of 76 which goes on the debit side of the accounts payable t account and ties back to our cash flow statement ouch did you survive that cash pay to suppliers is definitely one of the hardest numbers to calculate under cash flow from operating activities if you'd like to learn more about call accounting then i'll throw a link up here to a video that i've made about it previously so that was cash flow from operating activities and when we subtotal all of these numbers that we worked out we can see that the canons have generated 70 000 of cash inflow from their core operations but hold your horses we're not done yet next up we have cash flow from investing activities investing activities most commonly relate to the sale or purchase of non-current assets or investments in stocks and chairs that sit outside of a business's core operations in this cash flow statement we have cash flowing out of the business from the purchase of plant property and equipment or ppe for short and cash flowing back in from the sale of ppe you might have guessed it already but the balance sheet account that we need to calculate these numbers is plant property and equipment this account is an asset which is the a in dealer so it's a normal debit account and therefore our opening and closing balances go on the left hand side on the credit side we have the depreciation expense because the value of non-current assets reduce as they depreciate credits non-current assets in the balance sheet debit depreciation expense in the income statement now i don't want to over complicate things in this tutorial so we're going to keep ppe simple and make a few assumptions at this point we're going to ignore accumulated depreciation assume no gain or loss on disposal and that all cash related to these transactions has changed hands and finally that the cannon spent 70 000 purchasing ppe this year i know that's a lot of assumptions but we don't have a fixed asset register for this example so we'll leave it at that i'll probably do a whole video in the future covering fixed assets and appreciation now that we've cleared that up all that's left to include are cash paid to purchase ppe and cash receipts on sale of ppe the prior year balance sheet shows a closing balance in ppe of 202 the current year balance sheet shows a closing balance of 234 and we can see that the depreciation expense in the income statement was 23. i just said that we can assume that the canon spent 70 000 on the purchase of ppe and that all their cash has changed hands so we would credit cash by 70 to decrease it and debit ppe by 70 to increase it that leaves us with cash receipts from the sale of ppe on the credit side which we now need to solve for a closing balance of 234 less cash paid of 70 less an opening balance of 202 and adding back the depreciation expense of 23 gives us cash receipts on the sale of ppe of 15 so cash would be debited by 15 to increase it and ppe would be credited by 15 to decrease it both cash paid to purchase ppe and cash receipts on the sale of ppe tie back to our cash flow statement and when we subtotal all of these we see a cash outflow of 55 000 from investing activities cash flow from investing activities is an important section of the cash flow statement because it can significantly offset the cash flow generated from operating activities last up we have cash flow from financing activities and don't worry we've got all that hard work out the way this section is going to be quick financing activities relate to transactions involving businesses owners or lenders in this case we're dealing with lenders because we have proceeds from long-term borrowings of 20 000 and the number is very simple to calculate we take the closing balance of long-term borrowings in the current year balance sheet of 100 and we take away the closing balance from the previous year of 80 100 less 80 is 20 so we have a net cash inflow of 20 000 from financing activities now let's take the total of all these cash inflows and outflows that we have worked out we can see that the cannons have a net cash increase of 35 000 for the current year which ties to the movement in the cash balance which we can see below and which we can get from the balance sheet the closing cash balance for the current year of 185 less the closing balance from the prior year of 150 gives us a 35 000 increase in cash so there we have prepared the charlie cannon's cash flow statement using the direct method working out all of the numbers manually using the income statement and balance sheet that was hard work wasn't it this is only a simple example you can imagine that this whole process is more complicated for larger companies with more complex transactions which is why most of them actually avoid this process altogether because it can be too expensive and time consuming for their accountants to work out cash flow using the direct method the majority of large corporations tend to opt for the indirect method instead which is the subject of our next video the indirect method has the benefit of being much easier to prepare however it's less useful to investors what is the indirect method of preparing a cash flow statement so what's the difference between the direct and indirect method anyway the cash flow statement along with the income statement and the balance sheet make up the three major financial statements we use the cash flow statement to summarize the movement of the cash balance in the balance sheet over a period of time typically a quarter or a year and we do this by summarizing all of the cash inflows and outflows into three categories cash flow from operating activities cash flow from investing activities and cash flow from financing activities the latter two sections cash flow from investing and financing activities are completely identical whether using the direct or indirect method the only section that's different is cash flow from operating activities which is why i want to focus on that one in this video operating activities are the principal revenue generating activities of a business these are the transactions that take place on a regular basis under the indirect method there are three steps to calculating cash flow from operating activities and i'll take you through them right now first of all we need the businesses net profit or loss which we can find in the income statement this method relies on starting off with net profit and adjusting it for non-cash transactions again and again until we're left with only net cash inflow or outflow most large companies account using the accrual basis which means their profit does not equal their net cash inflow under the accrual basis revenue is recognized when it's earned not when cash is received and expenses are recorded as they are incurred not when cash is paid out so revenue doesn't equal cash inflow and expenses don't equal cash outflow which brings us on to the second section we need to add back all of the non-cash expenses that exist in the p l typically non-cash items relate to things like depreciation amortization or the gain or loss on disposal of non-current assets these don't represent cash outflows but they are deducted in our income statement when coming to that net profit so it's logical that we need to add these back in order to remove them from our calculation the third and final step is that we need to adjust for the movement in working capital working capital is simply current assets less current liabilities current assets are generally made up of inventory and receivables whereas current liabilities are made up of payables to work out whether you need to add or subtract these movements in the calculation you need to consider the impact they have on the cash balance an increase in inventory means a business has less cash because it has bought more inventory than it has sold and on the flip side a decrease in inventory means a business has more cash because it has sold more inventory than it has bought the situation with accounts receivable are very similar because they are also assets an increase in receivables means less cash has been recovered from customers so the cash balance goes down and a decrease in receivables means more cash has been collected so the cash balance goes up on the other hand payables are a liability so they work the opposite way to inventory and accounts receivable an increase in payables means more cash because less has been paid out to suppliers who the business owes money to and lower payables means less cash because more has been used to pay the bills cash flows from non-current assets and non-current liabilities tend not to be included under cash flow from operating activities because they're normally categorized in the other two sections cash flows from investing activities and cash flows from financing activities now that we've worked out the basic calculation for cash flow from operating activities let's practice using this template with a worked example we'll continue with that chudley cannons example that i took you through in the previous two videos last time i showed you how to calculate cash flow from operating activities with the direct method and today i'm going to show you how to do it using the indirect method instead and we're starting right now step one we first need to jot down the net profit figure because this is our starting point that we will make adjustments to in order to come to that net cash flow net profit can be found easily at the bottom of the income statement in this case the cannons have made a net profit of seventy thousand dollars for the year so we write this down at the top of the calculation next we have step two this is where we need to add back all of those non-cash expenses that are shown in the income statement we've got to reverse these out of our net profit in order to get closer to the cash flow figure to do this we look over the income statement and search for any depreciation amortization or gain or loss on disposal of non-current assets in this case we can only see depreciation of 23 000 so we need to add back 23 into our calculation to adjust the depreciation finally in step 3 we need to adjust for the movement in working capital like i said before working capital is made up of current assets less current liabilities let's have a look over the balance sheet and see what current assets we have i can see cash accounts receivable and inventory plant property and equipment is a non-current asset which affects cash flow from investing activities so we can ignore that and cash is what we're reconciling back to in the cash flow statement so we can ignore that one as well we are left with only inventory and accounts receivable a closing balance in inventory of 94 less the opening balance of 68 gives us an increase in inventory of 26 increases in inventory are represented as deductions in calculating cash flow from operating activities because the business has spent cash on purchasing the raw goods or by manufacturing them so we enter negative 26 into our calculation now let's look at accounts receivable here we have a closing balance of 120 and an opening balance of 98 which gives us an increase of 22 during the course of the year increases in accounts receivable need to be deducted from our net profit in calculating the cash flow from operating activities because higher receivables means that less cash has been recovered by the business from its customers so we enter negative 22 into our calc as well that's the movement in our current assets but we also need to find the movement in our current liabilities so that we've considered all of the working capital reviewing the balance sheet one more time shows us that our current liabilities are made up of accounts payable salaries payable interest payable and income tax payable long-term borrowings as suggested by their name are non-current liabilities which relate to cash flow from financing activities so we can ignore them here whereas share capital and retained earnings relate to equity so these can be excluded as well we are left with only these four current liabilities the sum of their closing balances is 156 and the sum of their opening balances is 131. when we take the difference between these numbers we have an increase in payables of 25 000 during the year increases in payables need to be added to our net profit in order to calculate cash flow that makes sense because you can imagine that if a business doesn't pay its invoices then it gets to hold on to its cash so we add back 25 in our workings but that steps one to three completed all that we need to do now is take the total of those numbers and we're left with the net cash inflow from operating activities of 70 000 that wasn't so bad was it we've come to this number using the indirect method but a quick check of our calculations using the direct method shows that we also came to 70 000 cash inflow from operating activities we get the exact same answer using either technique so which is better if you've watched my other videos on the direct method then you'll notice that the indirect method is much much quicker which is why most large companies using the accrual basis of accounting tend to work out their cash flow this way but if that's the case then why didn't everyone do this i suppose it really comes down to how the workings of cash flow from operating activities are presented in the cash flow statement the layout using the direct method is far more intuitive to read because it mirrors the cash basis income statement we have the cash receipts from customers at the top and below that we have the cash paid out to all of the various suppliers and stakeholders it makes easy reading for investors who might be glancing over the cash flow statement to extract meaningful information from it on the other hand the layout of cash flow from operating activities under the indirect method is far less intuitive you can think of the indirect method as a shortcut to working out cash flow from operating activities which is a win for the accounting for bookkeeper who's preparing it because it saves them time however the third parties who are reviewing the finished cash flow statement lose out because this report isn't as useful to them like i mentioned earlier we skipped over cash flow from investing and financing activities in this video because these sections are identical under the direct method how do you make a cash flow statement a cash flow statement is a financial statement that summarizes a business's cash inflows and outflows over a period of time we'll get into how that works in a moment but first why do we need a cash flow statement in accounting there are two main methods for preparing your books the cash method and the accrual method with a cash method you recognize your revenue when cash is received and you record your expenses when cash is paid out but under the accrual method you recognize revenue as it's earned and record your expenses as they are incurred so what does that mean if you're cash accounting then technically you only have one financial statement the income statement it summarizes your revenues and expenses over a period of time leaving you with a profit or a loss but with the cash method we said that you recognize revenue when cash is received and you record expenses when cash is paid out that leaves you with a net cash inflow or an outflow so the income statement prepared under the cash method is equivalent to a cash flow statement keep that in mind we'll come back to it later plenty of small businesses do their books this way which is fine but the cash method isn't allowed under ifrs or gaap if you're following either of these then you must use the accrual method so revenue must be recognized as it's earned and expenses must be recorded as they are incurred in accrual accounting we still have the income statement but this time it represents what a business has earned and incurred not is cash inflows and outflows so it's not equivalent to a cash flow statement so businesses using the accrual method keep a separate cash flow statement alongside their income statement and they also keep a balance sheet which holds their assets their liabilities and their equity not long ago i made videos covering the income statement and the balance sheets you can find links to both of those down in the description what is a cash flow statement at the start i said it summarizes a business's cash inflows and outflows over a period of time but what does it look like we begin with the opening cash amount at the start of the period and compare it against the closing cash amount at the end of the period you can find both of these numbers in the balance sheet the movement between the two is the net increase or decrease in cash and once we know that then we can get onto the real purpose of the cash flow statement explaining how we ended up here there are three main sections cash flow from operating activities cash flow from investing activities and cash flow from financing activities operating activities are the main revenue generating activities of the business these are the cash flows involved in selling goods or services investing activities sit outside of the businesses core operations they involve the buying or selling of investments or other long-term assets and finally financing activities relate to funding the business through raising or repaying cash to third-party banks or the owners of the business this my friends is the basic structure of the cash flow statement positive numbers represent cash inflows and negative numbers are cash outflows now there are a couple of ways to make a detailed cash flow statement we can use the direct method or the indirect method we'll start with the direct method cash flow from operating activities under the direct method mirrors the income statement prepared under the cash method which we saw earlier at the top we have cash receipts from customers which mirrors revenue and then we have the cash paid out to suppliers and employees and then interest and tax is paid collectively these mirror the businesses expenses cash flow from investing activities includes cash outflows from buying investments or other long-term assets and the cash inflows that come with selling them cash flow from financing activities relates to the raising or repaying of cash or capital there are two ways a business can do this using liabilities or equity they can borrow money from a third-party bank which would increase their liabilities or a business can look to its owners its shareholders who can make capital contributions which increase equity on the flip side they also make loan repayments back to the bank and distribute dividends back to the owners when we add up the net cash flows from operating investing and financing activities we can reconcile the net increase or decrease in cash back to the movement in the balance sheet now how does the indirect method work the only section that changes is cash flow from operating activities we use three steps to work it out the indirect method always begins with the net profit or loss from the income statement then in step two we add back all the non-cash expenses that appear above it these don't represent cash outflows and they need to be reversed out the usual suspects are depreciation and amortization and any gain or loss on the sale of non-current assets or long-term assets finally we adjust for the movement in working capital working capital is the difference between current assets and current liabilities increases in current assets like inventory or receivables reduce cash flow whereas increases in current liabilities like payables increase cash flow you can find all of these numbers on the comparative balance sheet now you're probably thinking that the direct method sounds a lot easier why don't we just use that you're right it is easier to read but it's actually harder for accountants to prepare so we don't use it as much the indirect method is much much easier to work out because we can find a lot of these numbers in the income statement and the balance sheet as you'll see in this next example i've realized that there's a lot going on here so i've put together two cheat sheets covering the direct and the indirect cash flow statement i like to think of them as one page reference guides to help you out if you'd like to support the channel then you're welcome to buy them on my website the link as usual is up here and down there how do we make a cash flow statement yes it's time for that example and we'll be using the indirect method because it's easier we'll need a couple of things to get started first we need an income statement here's one for a business called tumble which is a fictional dating app we actually made this one from nothing in the income statement video so check that out and maybe click subscribe as well it summarizes tumble's revenues and expenses for the year ended december 31st and here's tumble's balance sheet which we made in the balance sheet video it shows us a snapshot of their assets liabilities and equity at the end of the year but hold on we're using the indirect method so we actually need to see last year's balance sheet as well so this is tumble's comparative balance sheet we have the current year one on the left and last year's one on the right nice one more thing before we begin here are some key facts which happened during the year tumble sold some furniture for ten thousand dollars which originally cost them twenty thousand dollars and had been depreciated by five thousand the loss on the sale was charged to general and admin expenses tumble also spent nine hundred and ten thousand dollars on computer equipment they raised one hundred thousand dollars in long-term debt and made no repayments and finally they issued fifty thousand dollars in common stock and paid out one million dollars in dividends righto let's begin what are we reconciling cash this is a cash flow statement after all so let's head over to tumble's comparative balance sheet we can see that they held 13 million 895 000 in cash at the end of last year and this number increased to 17 million dollars at the end of this year so we can lift these numbers and place them at the bottom of our indirect cash flow statement overall that's a net increase in cash of three million one hundred and five thousand dollars but how did tumble pull this off let's find out we'll start with cash flow from operating activities in step one we need to find tumble's net profit or loss for the current year that's easy we can get it from the income statement on the bottom line we can see that tumble earns 9 million 650 000 this year from their core operations we'll take tumble's net profit and put it right at the top of cash flow from operating activities step two we need to reverse out all of the non-cash expenses non-cash expenses appear above the bottom line in the income statement some classic examples are depreciation and amortization these represent the gradual process of writing off long-term assets they aren't cash flows this year tumble incurred 850 000 in non-cash expenses so we'll add this back in our cash flow from operating activities but that's not all tumble made a loss on the sale of long-term assets if we jump back to our key facts page we said that they sold some furniture for ten thousand dollars so let's quickly do some workings this furniture originally cost tumble twenty thousand dollars and by the time it was sold it had incurred five thousand dollars in depreciation leaving it with a carrying value of fifteen thousand dollars tumble sold this furniture for ten thousand dollars which left them with a loss on the sale of five thousand dollars this is also a non-cash expense and it was charged to general and admin expenses in the income statement we need to reverse it out in our cash flow statement so we'll add back a loss on the sale of furniture five thousand dollars step three we need to adjust for the movement in tumble's working capital working capital is the difference between current assets and current liabilities ignoring cash current assets are typically made up of inventory and receivables and current liabilities are payables we can find the movement in all of these on tumble's comparative balance sheet it doesn't look like tumble has any inventory but they do have some receivables accounts receivable are the receivables and prepaid expenses which add up to 40 million fifty thousand dollars in the current year and eight million eight hundred and fifty thousand dollars last year that's an increase in receivables of 5.2 million during the year an increase in receivables reduces cash flow so we subtract 5.2 million dollars from cash flow from operating activities i like to think of it this way if receivables have gone up then tumble is owed more money which isn't good for cash flow payables work in a similar way tumble has accounts payable taxes payable accrued expenses and some deferred revenue all of this adds up to 14.4 million dollars in payables in the current year and last year they had 14 million 850 000 in payables that's the year-on-year decrease in payables of 450 000 we subtract decreases and payables under cash flow from operating activities because if payables go down then more supplier accounts have been settled so there's less cash when we take tumble's profit and back their non-cash expenses and adjust for the movement in working capital then we can see that they had a net cash inflow of four million eight hundred and fifty five thousand dollars from operating activities a couple more things we need to do here to finish this off but first i'd like to say a big thanks to all my channel supporters you guys motivate me to keep on making more accounting tutorials if you'd like to sign up then you can click the join button next up is cash flow from investing activities we're done with operating activities so the rest of the cash flow statement is the same whether you're using the direct or the indirect method on our key facts page we can see that tumble spent 910 000 on computer equipment this is a cash outflow from investing activities because they've bought long-term assets but tumble also sold the long-term asset remember that furniture we talked about tumble made a loss on its sale which we called a non-cash expense we added it back in cash flow from operating activities but we also need to record the cash receipt on the sale of ten thousand dollars this sale isn't part of tumble's core business so we record it as a cash flow from investing activities when we total it against the purchase of computer equipment that leaves us with a net cash flow from investing activities of nine hundred thousand dollars this time it's a cash outflow so the number's negative cash flow from financing activities financing activities involve raising or repaying cash or capital used to fund a business on the key facts page we can see that tumble raised 100 000 in long-term debt this is a liability to a third party bank and this year they made no debt to repayments they issued 50 000 in common stock which is a capital contribution from the shareholders who own the business which increases equity and they paid one million dollars out in dividends back to these shareholders that would have decreased their equity we can pull all these numbers through into cash flow from financing activities tomball received 100 thousand dollars in cash from long-term debt they raised another fifty thousand dollars in equity and they paid out one million dollars in dividends so that's a net cash outflow from financing activities of eight hundred and fifty thousand dollars almost there when we total the cash flows from operating activities investing activities and financing activities we can see that tumble had a net increase in cash of three million one hundred and five thousand dollars during the year this matches the movement in cash that we saw in the balance sheet so we've reconciled this cash flow statement using the indirect method before we move on from financial statements i'd like to share what i believe is the key to understanding them specifically the balance sheet and the income statement so let's do this financial statements are accounting reports that summarize a business's activities over a period of time essentially they give the businesses investors lenders and creditors an idea of its financial health but how do they work exactly it all boils down to one basic principle the stuff that a business owns is equal to the stuff that a business owes seriously that's all there is to it a business owns assets and it owes liabilities to third parties but it also owes equity to the people who own the business for a company that's listed on a stock exchange that would be the shareholders so we have assets are equal to liabilities plus equity or shareholders equity which is what we call the accounting equation now you might be thinking how does this have anything to do with financial statements and the answer to that is this equals sign this equal sign tells us that a business's assets always have to balance with its liabilities and equity in fact when we pick a business and look at this accounting equation at a single point in time then we're looking at a balance sheet this balance sheet is for a business called cash me if you can which makes microchips and computer stuff and what we're looking at is a snapshot of cash me if you can't assets liabilities and equity at a single point in time essentially it's a summary of what they own and what they owe on december 31st great but at the start of this video i said that i'll show you the key to understanding financial statements and we haven't quite got there yet here's the balance sheet but where's the income statement let's go back to the accounting equation assets equal liabilities plus equity or the stuff that a business owns is equal to the stuff that it owes to third parties and its owners but let's focus on equity what kind of stuff does a business owe to its owners two things it shows them their capital contributions and the businesses retained earnings capital contributions is the money that the owners take out of their own pockets and invest in the business for example if cashmere if you can issue some shares and you buy one then you've made a capital contribution now you're a shareholder and you're a part owner of the business okay so what's the deal with retained earnings then these are the businesses accumulated profits that it's holding on to for the future and this doesn't mean a huge pile of cash that just keeps on getting bigger and bigger cash and profit are two very different things profit is the financial benefit that a business gains when its revenues are bigger than its expenses and the businesses accumulated profits held for future use is called its retained earnings this is what's left over after we add up all of the profits that the business has generated and take away what's been withdrawn by the owners and that looks a little something like this retained earnings are made up of opening retained earnings which is last year's retained earnings carried forward into the start of this year plus current year profits which is the difference between revenues and expenses minus current year withdrawals the profit distributions to the owners or shareholders of the business which i'm pretty sure you've heard of we often call them dividends i like to think of this as the expanded accounting equation and in my opinion it's the key to understanding financial statements let me show you why if we jump back into cash moviecan's balance sheet we can see what the business owns and what it owes on december 31st they own 1 million 551 000 in assets and the same amount in liabilities and equity because these two sides of the balance sheet are in balance now if we zoom into the equity section we can see that cash me if you can owes one million three hundred and forty two thousand dollars to the owners of the business its shareholders of which 100 000 is made up of capital contributions that the owners have put into the business and 1 million 242 000 in retained earnings or profits held for future use now here's where things get interesting if we expand retained earnings we can see what they're made of last year's retained earnings which came to one million two hundred and fifteen thousand five hundred dollars less the current year dividends which were ten thousand dollars this number is negative because these profits have been withdrawn by the shareholders and we can also see that this year cash kashmifi can generated 36 500 in profit where did they get this number from current year profit comes straight from the income statement which looks like this the income statement summarizes a businesses of revenues and expenses over a period of time it's financial statement just like the balance sheet but this one tracks kashmifi cans performance over a one year period and tells us how profitable they are pretty cool hey so if you go back to the accounting equation and expand it out we can see that retained earnings is the key that links together two of the most important financial statements the income statement and the balance sheet so here we are at the end of the accounting cycle step eight it's time for us to post closing entries what are closing entries closing entries are tucked away at the very end of the cycle in step 8. we post them at the end of each accounting period after we're done creating financial statements but what are they exactly closing entries are journal entries that reset temporary accounts to zero they transfer their balances into retained earnings which is a permanent account held in a balance sheet remember a journal entry is a record of a financial transaction and retained earnings are a businesses profits held for future use but what are temporary and permanent accounts let me show you if you've watched my videos before then you're probably familiar with dealer but if you're new here dealer is a handy little acronym that can help us remember debit and credit accounts it stands for dividends expenses assets liabilities equity and revenue dividends expenses and assets are normal debit accounts whereas liabilities equity and revenue are normal credit accounts but here's the thing some of these are temporary accounts and some are permanent any idea which is which hmm i'll grab a drink while we think about it got it no worries if not here's a little trick to help you remember red ale revenue expenses and dividends are temporary accounts and assets liabilities and equity are permanent accounts well i don't know about you but i'll cheers to that actually it's a bit early yeah we'll put that away you can find dealer and red l on my closing entries cheat sheet which i'll leave a link to down in the description just be in so permanent accounts assets liabilities and equity these guys live in the general ledger and their balances are always carried forwards from one accounting period into the next on the other hand revenue expenses and dividends are temporary accounts these also belong in the general ledger but they only correspond to one accounting period once that period's over they need to be reset to zero and we do that using closing entries if none of this is making sense don't sweat it i think this example might help clear things up happy new year this is a trial balance for a business called unter a late comer to the world of ride sharing apps a trial balance is an accounting report showing the current balances in every general ledger account and this is an opening trial balance because the date is january 1st the start of hunter's new financial year if we flick back to the accounting cycle we find ourselves right here at the very beginning now let's see how hunter's temporary and permanent accounts change as we move around this at the moment they have some assets some liabilities and some equity a-l-e which means that all of these are permanent accounts making up unters balance sheet but hang on where's revenue where's expenses and dividends trial balances often have filters applied so that they only show accounts with numbers in them if we expand this out then we find the usual suspects revenue expenses and dividends red these are untested temporary accounts which were reset to zero at the end of last year okay great now let's skip through steps one to six and get on to the good stuff the adjusted trial balance unter drivers have been diligently moving customers from a to b for a whole year now and we find ourselves at december 31st his adjusted trial balance a whole year's worth of transactions have been posted and adjusted so that this represents a true and fair view of their business as you can see all of the temporary red accounts have got numbers in them now these show us the revenue the unter has earned the expenses that it's incurred and the dividends that it's declared during the past year now unter can create some financial statements revenue and expenses are temporary accounts that make up unters income statement this summarizes unto's performance over a one year period we can see that they've made a tidy profit of three million nine hundred and fifty thousand dollars but while the income statement only looks at revenues and expenses unters balance sheet is made up of everything all of unter's permanent and temporary accounts belong in here assets liabilities and equity are permanent accounts whereas current year dividends is a temporary account and current year profit feeds directly through to here from the income statement which as we saw is made up of temporary revenue and expense accounts unter has earned three million nine hundred and fifty thousand dollars in profit and they've declared half a million dollars in dividends step eight time to post the closing entries i'm going to show you two ways to do this the long way and the short way the long way involves four steps and we'll move through these one by one in step one we're going to reset unter's revenue account to zero by transferring the balance to the income summary account what is an income summary account it's a very special very temporary account that only exists while we're posting closing entries and it works a bit like this if we go back to the adjusted trial balance we're going to reset revenue to zero but be careful with this because i can see three accounts with revenue in their descriptions accrued revenue deferred revenue and revenue revenue accrued revenue is an asset and deferred revenue is a liability they are both permanent accounts that we use for adjusting entries so we can leave them alone for this example we're only interested in this temporary revenue account so let's take a closer look at it unter earned 20 million dollars this year this sits on the right hand side of their revenue t account because revenue is a normal credit account think dealer we want to reset this temporary account to xero so we need to post a closing journal entry on december 31st we'll debit revenue by 20 million dollars and credit the income summary account by the same amount as you can see this transfers the balance from the revenue account to the income summary account so we're left with zero dollars in revenue and 20 million dollars in the income summary account step two now we need to do the same thing again but this time with all of the expense accounts we'll reset them to zero and clear their balances to the income summary account unter has four different expense accounts cost of services overhead expenses interest and tax we can ignore the crude expenses because it's a permanent liability account we need to post another closing entry and repeat what we did back in step one expenses are normal debit accounts so their balances are on the left of these t accounts if we want to reset them to nil then we need to post equal and opposite credits to each account the cost of services overhead expenses interest and tax and that leaves us with a total balancing amount of 16 million fifty thousand dollars which will debit to the income summary account in every journal the total in the debit column has to match the total in the credit column when we post this one we credit the right hand side of each expense account resetting all of them to zero and we debit the left hand side of the income summary account now it's got a new balance of three million nine hundred and fifty thousand dollars which is a net credit sitting on the right hand side sound familiar it should do because this number is exactly the same as unters profit for the year which we saw in that income statement step three it's time for us to clear out that balance in the income summary account and put it where it belongs retained earnings which is a permanent equity account in junta's balance sheet back to our trial balance here's our income summary account and it has a 3 million 950 000 credit balance which is a combination of hunters revenues and expenses for the year the closing entry for this one is nice and simple we have a three million nine hundred and fifty thousand dollar credit balance in the income summary account so we need to debit it by the same amount and credit the balance to retained earnings when we post this unters retained earnings or their profits held for future use increases to 13 950 dollars and bye bye income summary account sorry this just isn't working out between us you know you're going to make a lucky accountant really happy someday so job done right not quite step four we need to reset current year dividends to zero and clear the balance to retained earnings unter declared half a million dollars of dividends this year these are the businesses profits that they've chosen to distribute to the owners of the business it's shareholders and we know retained earnings are a businesses profits held for future use so if unter issues dividends then it's not holding on to these profits anymore so it's retained earnings are going to go down as you'll see right now unter has 500 000 of dividends which is a normal debit account so in this closing entry we're going to credit the dividend account by five hundred thousand dollars and debit retained earnings by the same amount when we post this closing entry unters dividends are reset to nil and its retained earnings decrease to 13 million four hundred and fifty thousand dollars just as we predicted now can i get a drumroll please this is unters post closing trial balance it shows us what's left in each of unters accounts after posting their closing entries you can see that all of their temporary accounts have been reset to zero and their balances have been transferred to retained earnings gee that took a while didn't it thankfully there's a quicker way the short way this time we're going to take all of unter's temporary accounts its revenue expenses and dividends and clear their balances to retained earnings using one closing entry so let's rewind and go back to the adjusted trial balance here are unters temporary accounts we have revenue in the credits column and we have dividends and expenses in the debit column we can reset all of these to zero using one closing entry by debiting the revenue account and crediting the dividend and expense accounts the balance of three million four hundred and fifty thousand dollars is credited to retained earnings because in double entry accounting there are at least two equal and opposite sides to every transaction when we post this closing entry all of the temporary accounts are reset to zero fantastic we covered a lot there didn't we so here's a quick recap when we post closing entries the long way there are four steps first we clear revenue to the income summary account then we clear expenses to the income summary account then we clear the balance in the income summary account to retained earnings and finally we clear the dividends straight to retained earnings this might seem like a bit of a faff but if you're using a manual accounting system then the income summary account can help you methodically work your way through this closing process with the short way we clear all of these temporary accounts to retained earnings in one go often this happens automatically if you're using modern accounting software but whichever method you're using we get to the same post closing trial balance which usually looks like this filtered to hide accounts with zero balances the post-closing trial balance for this year becomes next year's opening trial balance so there it is the whole accounting cycle if you made it this far then give yourself a big old pat on the back because you deserve it and if you've got exams coming up soon best of luck i hope you crush those thanks thanks for watching and i'll see you soon